The number of retailer bankruptcies has jumped sharply in the last year, highlighting the heavy debt loads carried by L.A.-area companies such as American Apparel Inc., Nasty Gal Inc., and BCBG Max Azria Group.
The mass retail die-off is not unexpected as flagging brick-and-mortar sales and fickle consumers pushed many industry players further into the red over the last several years.
The recent spate of retailer bankruptcies has also illuminated another trend: Private equity firms saddling their portfolio companies with debt to pay themselves large dividends.
Beverly Hills’ Platinum Equity and Gores Group – run by billionaire brothers Tom and Alec Gores, respectively – are prime examples. Both companies have received hundreds of millions of dollars in the last year through special dividend payments financed by portfolio company debt. These payments included a $370 million disbursement made in September to Platinum from its government service business PAE.
Leonard Green & Partners, a Brentwood private equity shop, took a $700 million dividend from portfolio company BJS Wholesale Club Inc. in January, the third payout since acquiring BJS in 2011.
Credit rating agencies often respond to these maneuvers with criticism and occasionally issue a downgraded rating for the portfolio company, according to Christina Padgett, senior vice president of Moody’s Investors Service.
“In general, we look more harshly when a company borrows to take out a dividend,” she said. “It makes companies more vulnerable, typically, because all of a sudden they have a fixed cost they didn’t have before and they’ve removed value that would otherwise give companies a cushion or be put toward business ventures.”
Low interest rates and strong investor demand for high-yield corporate debt have counteracted the effect of these credit downgrades in recent years, meaning the practice hasn’t slowed down. Private equity firms have extracted $90 billion in debt-funded payouts since 2013, according to data published by S&P Global Market Intelligence.
Padgett said there’s nothing inherently wrong with financing dividends this way, but the market’s demand for corporate bonds is creating an unhealthy imbalance, especially in industries such as retail.
“If the reason you’re doing a dividend is because the company has outperformed expectations, that’s one thing,” she said. “If you’re doing a dividend because the market is desperate for debt, that says something different – you’re taking advantage of a market imbalance.”
Debt-financed dividends are already generating controversy in the retail space. Private equity-owned shoe seller Payless Inc. of Topeka, Kan., which filed for bankruptcy in April, is being pushed by creditors to rationalize some $350 million in dividend payments made to majority stakeholders Golden Gate Capital and Blum Capital.
Overleveraging a company can lead to negative consequences, according to a senior executive at an L.A.-area private equity firm who asked not to be named out of concern for alienating limited partners.
“Just like any other business, if you’re putting too much leverage on a company, it has to spend all its time and energy paying that down,” the executive said.
But the Payless situation represents an extreme case, the executive added, noting that dividend recapitalizations – the practice of taking out new debt to finance dividend payments – can also help prime a company for a later exit.
“In some cases, it’s a positive because it familiarizes the company with lenders and allows for another private equity buyer to finance a deal more easily,” the executive said.
Gaining leverage
Leveraging – and often releveraging – portfolio companies is a fundamental part of the private equity investment cycle, according to industry players.
Acquisitions are typically made using a blend of cash and bank loans taken out against the target company’s assessed value. Once those loans have been repaid in part, or a company’s revenue grows to the point where the ratio of debt to earnings before interest, tax, depreciation, and amortization falls, it’s then common practice for private equity shops to go back to a lender and take out new loans on the company in order to recoup some, if not all, of their initial investment.
It’s a profitable strategy and one that helps keep return rates stable throughout the lifecycle of a private equity firm’s funds.
Take the three BJS dividends paid out to Leonard Green as an example. Those payouts totaled $1.8 billion – roughly three times the firm’s initial equity investment in the company, according to Moody’s data. The first two disbursements came within 18 months of the initial deal, which totaled $1.1 billion. Such moves allow firms to show early returns to their limited partners and get back cash in hand, which allows them to put that capital back to work.
“If you invest $50 million cash for a $100 million acquisition and then two years later you can releverage and get $25 million back, you’ve made half of that investment back in a short period of time,” the private equity executive said.
Put another way, dividends are a sort of safety net, according to Padgett.
“It’s a way of ensuring a private equity fund and its investors get a return,” she said. “If they take a dividend out, they feel they come out whole regardless of the outcome.”
