HONG KONG (Reuters) - Private equity firms in Asia Pacific are increasingly paying special dividends to themselves funded by refinancing debt of the businesses they own, a development that is being fuelled by frothy credit markets and sluggish prospects for “exit” sales.
So-called dividend recapitalisation loans have been popular for some years in North America and Europe. Their growth in Asia is a sign the region’s leveraged finance industry is evolving from its conservative past, with local banks fiercely competing to provide loans even if it means loosening credit standards.
The attraction for a private equity firm is that it can recoup some or all of the cost of its stake in the business without selling out.
But the practice is controversial, raising concerns that companies are being burdened with heavier debt piles and thinner cashflows at a time when economic growth in Asia slowing.
“For the PE firms, recaps offer the benefit of being able to pull out cash without losing control,” said Andrew Palmer, a Standard & Poor’s credit analyst. “But they have to strike a balance to ensure they do not destroy the value in the company.”
Defenders of the “dividend recap” say the transactions can lower debt servicing costs and provide more flexible loan terms on cash-rich companies.
Critics say proceeds from new loans should go back into the business, and point to several cases where companies have crumbled under the weight of private equity-backed debt loads.
A typical private equity deal involves buying a company by borrowing around two-thirds of the purchase price and selling it later at a profit. In a dividend recap, a buyout firm borrows more money from lenders and then uses the company’s cashflow to pay itself a dividend.
Recaps are growing in popularity across all major markets as buyout firms seek to lock in favourable loan terms while interest rates remain near zero. Asia, excluding Japan and Australia, has seen a combined $3 billion of the deals in the last two years, according to Thomson Reuters LPC, up from small-to-zero volumes in previous years.
Another factor is that private equity firms are struggling to sell their companies, or find “an exit” in industry jargon, either to private buyers or through the IPO markets. Private equity-backed M&A volumes fell 34.3 percent in the third quarter to $24.8 billion, according to Thomson Reuters data.
A dividend recap allows a buyout firm to at least show a partial return on the investment - especially important to firms trying to finish investing one fund so they can raise another.
“The biggest danger to the borrowing company is whether they can afford the higher debt structure associated with making the dividend recap,” said CV Ramachandran, the Asia head of advisory firm AlixPartners.
Another risk in Asia, he added, is how fast cash squeezes can occur when foreign money flees.
One of the better-known U.S. examples of a dividend loan going wrong was Simmons Bedding Co. The Atlanta-based company filed for Chapter 11 bankruptcy protection in November 2009, with $1 billion of debt on its books after buyout firm Thomas H. Lee Partners recapped twice.
Asia also has examples of companies failing under the weight of buyout debt. Australian clothing and footwear retailer Colorado Group surrendered control of the business to its lenders in May 2011, owing the creditors $411 million.
Appointed receivers later closed 140 stores, which cost more than 1,000 jobs. Private equity firm Affinity Equity Partners bought the company through a leveraged buyout in 2006.
Recaps soared in popularity in the United States in the years leading up to the 2008 financial crisis, paused after the crash, but have since returned to favour in North America and Europe. The deals remained fairly rare in the Asia-Pacific region until recently, when they took off in Australia.
Then last month, Focus Media Holding Ltd, a Chinese display advertising company bought by Carlyle Group and other private equity firms, embarked upon a $500 million recap, just six months after a separate loan closed for the $3.7 billion buyout.
The deal is significant not just because it involves a China based company, but because it also involves a Chinese bank - both rarities for Asia’s leveraged finance industry.
“The next step is to educate the Chinese banks to do more leveraged recaps,” said Carlyle executive X.D. Yang, speaking at the SuperReturn private equity event in Hong Kong last month.
“I see this evolution happening quickly, and once one or two model deals get done then the rest of the industry can follow.”
A key source of funds for dividend loans in Australia has been the U.S. term loan B market (TLB) market - a loan depot where institutions such as hedge funds offer large loans with relatively few covenants for the borrower.
Issuance in U.S. TLBs from Australia is at $4.98 billion year-to-date, according to Thomson Reuters LPC, up from $531.4 million last year.
Australia based private equity firm, Pacific Equity Partners, has tapped the U.S. TLB market four times this year alone for dividend loans, Thomson Reuters LPC data shows.
“When we’ve done those dividend recaps, in the case of a couple of them we’ve actually reduced interest and cash interest costs, and we’ve improved covenant positions,” said Simon Pillar, PEP’s co-founder and managing director, speaking at the SuperReturn event.
Asia’s red hot bond market, coupled with competition from the U.S. TLB market, has prompted more local and foreign banks to offer dividend loans.
S&P’s Palmer said that, in some cases, he saw underwriting standards being loosened as a result.
“At what level of debt and interest rates can the company sustain its operations?” he said.
($1 = 1.0611 Australian dollars)
Additional reporting by Umesh Desai in Hong Kong and Prakash Chakravarti of Thomson Reuters Basis Point; Editing by Alex Richardson