Financial modeling is paramount in the dividend recapitalization decision-making process.

Recently, there has been a renewed interest by private investors, including Private Equity firms, in pursuing a strategy called "dividend recapitalization" (or "dividend recap," for short) at their investee companies. Very succinctly, a dividend recap is the return of cash by the investee to shareholders, funded by an increase in debt. A divided recap is the result of the following (somewhat simultaneous) steps by the company (each with their own intricacies):

• The declaration, issuance and payment of a special (extraordinary) dividend to shareholders
• The negotiation, authorization and issuance of new debt by the company

Private investors pursue dividend recaps in order to extract capital from the company as cash. In doing so, these investors can make alternative use of the cash, such as entering into other deals, or returning funds to their investors (LPs).

Dividend recaps have been the target of criticism (as see in this WSJ article), as recaps have the potential for increasing the risk of financial distress at companies. After all, the payment of a dividend means a reduction in equity, or the capital "cushion" that companies carry to weather different financing conditions.

Opposing (and more constructive) views hold that a dividend recap is able to help adjust the level of equity at companies, in a healthy and productive way. An excessive level of equity could mean low returns to investment. As companies' lifecycle progress and industries change, it is important for management and boards to observe such changes and reassess their capital structure mix. Ultimately, Corporate Finance teaches that capital should be used in projects with the highest net present value ("NPV") and in case the company finds itself in a de-risked position (e.g., maturing industry, excess capital) and can't justify holding excess capital, it should rightfully return it to shareholders. One such potential route to return capital is the dividend recap.

The decision-making around returning capital to shareholders is complex and there are no shortcuts. There is also no definitive answer from Corporate Finance theory as to the optimal mix of debt and equity in the capital structure. A considerable amount of discretion and judgement always comes into play.

Using quantitative tools to assess dividend recapitalization

So, how do investors, managements and boards put themselves in the best possible position when assessing returning capital to shareholders via a dividend recapitalization? As discussed above, there are certainly many considerations. Some of those include the legal and fair treatment of stakeholders and legal and fiduciary obligations required by their posts (e.g., directorship / board membership). Those considerations are beyond the scope of this short article. However, one aspect any capital structure discussion needs, and which is key to the successful assessment of returning capital to shareholders via a dividend recap strategy is the development and application of a quantitative tool, in the form of a comprehensive, integrated financial statement model. A sophisticated and complete financial model with the aim of sizing or quantifying the company's ability to take on new debt and release capital via a dividend is paramount for the following reasons:

1. Understanding cash-flows: an integrated, 3-statement financial model is the requisite tool for evaluating the company's ability to generate cash-flows with which to service debt (covering principal and interest) and other obligations (such as pensions and dividends). The systematic forecasting of cash flows that comes with an integrated financial model provides management with the clarity to analyze the recap proposition.
2. Debt covenants: the codifying of the debt covenants within the financial model (for instance, the EBITDA definitions) and flagging of covenant "trips" helps address the question of whether a dividend recap is a viable strategy for the company, and if so, at what level.
3. Valuation impact: Assessment of how the recap affects the company’s valuation and return on investment metrics. Markets could feasibly penalize low ROIC companies (and most likely do) and so the review of a recap with an eye to the impacts on ROIC and other valuation-impactful metrics is beneficial to the decision-making process.
4. Scenario analysis: Stress testing under various scenarios (e.g., economic downturns, changes in interest rates) to assess the potential risks and impacts on the company’s financial stability is of true importance in the dividend recap assessment.

A quantitative tool, in the form of an integrated financial statement model provides the clarity and information necessary for investors, management and boards when assessing return of capital strategies.

Wrapping up

Dividend recapitalizations have potential benefits but can also be risky for the investee company and for the private investor ("sponsor"). The decision to return capital to shareholders should be made cautiously and systematically, by looking at a multitude of factors. One step such a decision should include with all certainty is the analysis of the recap via the lens of a comprehensive financial model. This step is key to mitigate the risks of financial distress, for the company, as well as the reputation risks for the sponsor.

How can we help? We are specialists in financial modeling with several years of experience in working with clients in M&A, IPOs, Restructuring and Strategic Reviews, among others. Most times, when guiding clients through Corporate Finance decision-making processes, we develop and make use of quantitative tools such as integrated, three-statement financial models.

Please reach out if you are a private investor, management or a board member considering the benefits and risks of dividend recapitalizations. We'd love to discuss how we may be able to assist you in your decision-making process.

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