Debt investors have resigned themselves to supporting private equity dividend recaps

Fund managers are reluctantly buying the debt pumped up by companies to pay their private equity owners windfall dividends, as a lack of new credit supply and low yields limit investors’ choice of other attractive investments.

Buyout firms trying to raise cash from their investments have turned to so-called dividend recapitalizations at a record rate. Such deals give them juicy cash payouts, but are often unpopular with bond investors worried about the impact of the larger debt pile on the company’s financial health.

Last month Belron Group, which owns car windscreen repair companies in the US and UK, launched a dividend recap in which it would raise €8.1 billion and pay a €4.4 billion dividend in the largest transaction of its kind on record, according to PitchBook LCD.

But even though the dividend nearly doubled Belron’s total debt from less than €5 billion to nearly €9 billion and prompted ratings agencies Moody’s and S&P Global to downgrade Belron to junk territory, the deal was still massive oversubscribed, with demand more than seven times higher. than available debt.

“We all hate dividend recaps — as a bond manager, you just hate them,” said one investor who followed the deal and asked not to be named. “But that’s the market right now, and if I’m getting capital flows, I’ve got to buy something, so I’m going through it.”

The deal highlights the dilemma facing many debt fund managers, who fear being disadvantaged by private equity firms eager to extract cash from their portfolio companies but, with debt markets so buoyant, face a shortage of attractive investment opportunities. U.S. high-yield credit spreads, the premium for the cost of borrowing over Treasuries, fell below 3 percent this month for the first time since the 2008 global financial crisis, according to data from the Federal Reserve Bank of St Louis.

Overall, the net supply of leveraged loans hit minus $6.2 billion in September, meaning more loans were repaid than issued and marking the largest shortfall since February 2022, according to Fitch. Investors, bankers and analysts expect dividend recaps to remain popular until supply recovers.

“The theme of dividend recaps in 2024 and 2025 will become stronger, but investors continue to be very selective about credit,” said Chris Bonner, head of US leveraged financial capital markets at Goldman Sachs.

“The real question will be: are investors willing to capitulate and buy harder (lower-quality) credit, or will they continue to focus only on higher-quality names?”

The volume of leveraged loans backing dividend recaps hit a record high of more than $17 billion in September, and quarterly volumes are the highest in three years. Refinancings accounted for more than 71% of high-yield bond issuance from October 2023 to September 2024, the largest share in a 12-month period since 2016, according to LevFin Insights.

A recent study by Abhishek Bhardwaj, Abhinav Gupta and Sabrina Howell found that while dividend restatements increase the chance of a good outcome for a company’s owners, they make firms riskier and “raise the specter of bad outcomes for workers.”

“You have an immediate reaction to a dividend recap: it’s negative,” said one bond investor, adding that not all such deals are bad business, but that when it comes to issuers, “you have to be careful what as to who will be more aggressive than others.”

Other investors believe that as long as the company is healthy enough to take on the additional debt, then such deals are worth investing in.

“From our perspective, it’s a good deal,” said another bond manager, referring to the Belron deal. “Is it cheap? It’s probably not cheap – it’s fair value. But if you think about the economic context we are facing today. . . you want to own stable, stable, cash-flowing businesses in this type of environment.”

A Moody’s report on Thursday found that of 66 dividend-paying companies it examined, only five had defaulted. While “top private equity firms have taken on more debt” to fund dividends, “shortfalls from debt-financed dividend deals remain rare because these deals are typically done by LBOs with higher quotas (leveraged buyouts)”, it says.

Many buyout groups are turning to dividend recaps after struggling to return cash to their investors, with the slow pace of mergers and acquisitions and unattractive prospects presented by flotation preventing them from exiting their investments.

The lack of options available to fund managers means strong demand for Belron’s debt is not surprising, even though the deal is “simply a way to return money to shareholders,” said Lyuba Petrova, head of leveraged finance for the Americas at North to Fitch.

“Certainly, creditors can vote with their dollars whether they want to stay in the deal or not,” Petrova said. “But right now, there’s a net negative supply.”

In September, Focus Financial Partners — which, like Belron, is backed by Clayton, Dubilier & Rice — conducted the sixth-largest private equity-backed dividend recap in history, according to PitchBook. Investment firm 3i has carried out its eighth dividend recap from Dutch retailer Action this year, this time to pay itself a windfall of nearly €1.1 billion.

Belron declined to comment. Clayton, Dubilier & Rice did not respond to a request for comment.

With interest rates falling and default rates set to remain low, dividend recaps are likely to continue, investors said. However, a sudden economic downturn could change that.

“Big picture, these types of activities are still fairly minor and fairly discrete,” said Ashok Bhatia, co-head of fixed income investments at Neuberger Berman. But “if growth slows significantly . . . then the piper should be paid’.