It’s not quite money for nothing, but it might be the next best thing.
Tempted by lenders offering piles of cash at cheap rates, L.A. businesses are borrowing money and using it to pay big dividends to their owners. And they’re doing so at record levels.
Local investment bankers and lenders say so-called dividend recapitalizations – or, more simply, debt-funded dividends – have surged in popularity. Once used only by private equity firms to boost returns from their portfolio companies, more owner-operators are now using dividend recaps to take money off the table and hedge against an economic downturn. (See story, page 30.)
It’s a way of shifting financial risk from business owners to their businesses. The owner gets cash now, while the business is saddled with new debt. That’s fine so long as a business continues to perform, but the added debt can weigh on a company’s balance sheet, eating up free cash flow and making it difficult to borrow for other needs – or to weather a swoon in business.
Despite the risks, the market for dividend borrowing is hot. Through last month, U.S. companies have borrowed nearly $41 billion this year to pay dividends to their owners, according to S&P Capital IQ. That’s on pace to nearly match last year’s record volume of $69.9 billion and to easily surpass the prerecession high of $49 billion in 2006.
Those figures only capture loans taken out by large companies, but bankers and lenders said the dividend recap market has been similarly hot in L.A.’s vast middle market.
“Absolutely we’ve seen the activity over the last two years get bigger. It’s absolutely growing,” said W. Hunter Stropp, the Westwood-based president of publicly traded Boston lender THL Credit Inc., which offers dividend financing and other loans to middle-market companies. “And it can be considerably bigger than it is today.”
It’s a trend driven by a confluence of economic forces. Capital markets flooded with cash have prompted lenders to scramble to put all that money to work. Historically low interest rates have made it easier – and cheaper – to borrow. In addition, a roaring stock market has helped pump up the value of public companies and, in turn, boosted valuations for private companies, tempting owners to cash out.
The recession is still fresh enough in owners’ minds that they’re anxious to take money off the table and hedge their bets, said Jim Freedman, chairman of Intrepid Investment Bankers in West Los Angeles.
“The recession made business owners more aware of the riskiness of having all their eggs in one basket,” he said. “The attractiveness of these dividends is that owners can take out some cash and have more security going forward. They’re more cautious now.”
Dividend recaps can be a good deal for business owners, giving them a chance to diversify their holdings without selling their companies. But the ramp up in dividend lending also rings alarms for some investors, who see the vast amounts of debt, low rates and increasingly easy loan terms as signs of an overheated market with too much risk and not enough return.
Bruce Munster, a managing director with Morgan Stanley Wealth Management in Woodland Hills, said he’s steering clear of investment funds that have exposure to these types of loans.
“If you’re coming in now as an investor, it’s a lot like 2007 and you don’t know how long things are going to last,” Munster said. “But while the music is playing, people are going to dance.”
Raul Anaya, Bank of America’s market president for greater Los Angeles, said he’s been helping private equity firms with debt-funded recaps for more than a decade. But it’s only been in the past four or five years that he’s seen other types of companies – usually smaller ones – doing these deals.
“It’s come down to the middle market, to family-owned businesses and companies owned by entrepreneurs,” Anaya said. “It’s something that’s really being embraced.”
Embraced not only by bankers and other lenders, but by business owners and the investment bankers who advise them, Stropp said. As lenders, investment bankers and business owners see more dividend recaps happening, they want to get into the market themselves.
“As much as anything, I think it’s just been an education over time,” he said. “Business owners are catching on to it and middle market investment banks have grown more familiar with the product.”
The same, he said, is true of wealth managers, attorneys and accountants who work for business owners.
Anaya said Bank of America and other institutions have been more willing to finance dividend recaps over the past few years because demand for other types of loans has been low.
“As loan demand became more sluggish, banks have become more comfortable with the idea of financing a dividend,” he said. “We’ve gotten comfortable letting that trickle down to the lower middle market to generate more loans and be a solution to business owners.”
And for big banks, dividend recaps offer yet another benefit: Business owners who suddenly have millions in cash to invest make for good wealth management clients.
“We’re advising some clients that, as a way to diversify, they can pay themselves a dividend,” Anaya said. “Then we introduce our wealth management bankers to help them preserve and enhance their wealth.”
To lenders, the beauty of a dividend recap is that it’s a way to lend money to a company – almost always a healthy one – that otherwise has no need for a loan.
Peddling unnecessary debt seems like a recipe for trouble – the business equivalent of doling out home equity loans to borrowers who wind up buying new Jet Skis. And Anaya conceded that it goes against commercial banks’ typically conservative practices. But he’s only pitching dividend recap deals to businesses that meet several criteria. They’re healthy, they don’t have much existing debt, and they don’t have any acquisition or expansion plans.
“It’s for clients who don’t have any place else to deploy their cash flow,” he said.
In many cases, business owners are not seeking out dividend recap deals. Rather, they’re being approached by lenders, said Ryan Bernath, head of investment banking at B. Riley & Co. in West Los Angeles.
The sheer number of lenders in the market, he said, has led to fierce competition and ever more attractive loan terms.
“The universe of folks willing to lend you money is bigger,” Bernath said. “You’re not only talking to City National, Wells Fargo and JPMorgan, but all these specialty finance companies. That’s driving all lenders to be really aggressive. They’re doing things today that in a tighter credit market they’d never be doing.”
Rates are lower than they were just a year or two ago, Bernath said, and terms have gotten easier. Lenders are often willing to waive common safeguards, such as requirements that a borrower hit quarterly revenue targets.
“There are very relaxed covenants that take the teeth out of these deals,” he said.
Another sign of the increased competition is that lenders are pitching dividend recaps to more businesses. A few years ago, Bernath said that lenders would only offer dividend recap deals to private equity firms. Now, they’re reaching out directly to owner-operators.
That is in part because even as dividend recaps have become more common, some business owners don’t know that a debt-funded dividend is an option, said Jonathan Zucker, head of the capital markets group at Intrepid.
“Especially for a middle-market, family-owned company, they know they can sell the company or sell a piece,” he said. “But they probably don’t know a debt recap is available to them.”
Once they find out, business owners see dividend recaps as an attractive option, said Andrew Apfelberg, a partner at Century City law firm Greenberg Glusker who represents companies in sale and capital raising transactions.
Older business owners, he said, might be more likely to sell because they’re ready to retire. But more middle-age owners, see a dividend recap as a way to protect their own net worth while also letting them continue running – and hopefully growing – their businesses.
And then there is Calabasas hardware retailer Harbor Freight Tools, a kind of poster child for the dividend recap. Every few years, the company takes out an increasingly larger loan to pay off old debt and fund a dividend to Chief Executive Eric Smidt and other co-owners.
The company’s latest dividend recap was for a cool $1 billion, about $256 million of which went to pay a dividend. The rest paid off the last dividend loan.
Out of pocket
At the same time, taking a dividend now doesn’t mean you’ll get to keep it, said Rob Babek, a partner in the Century City office of accounting firm Marcum. He said he’s seen business owners take cash out in a dividend, only to put that money back in their companies later when they ran into trouble.
“A business may be very profitable for several years and the owners take out large sums,” he said, “and then business starts to decline and they have to put money back in.”
In other cases, he said he’s seen banks refuse to give a business a loan unless the owner makes a personal guarantee, putting their dividend cash at risk.
“You never know how things are going to go,” he said. “It’s like anything else. There’s risk involved.”
One L.A. business owner and Intrepid client who recently took a debt-funded dividend said he hadn’t considered the possibility until it was presented to him. The owner spoke on condition of anonymity because he signed a confidentiality agreement as part of the deal – and because he said his clients might be turned off if they knew how much cash he just took off the table. Other business owners who have done dividend recaps declined to speak with the Business Journal, citing similar reasons.
Earlier this year, the business owner got a buyout offer of nearly $40 million from a competing company and hired Intrepid to represent him, despite assuming the investment bank wouldn’t find any buyers willing to pay more.
“I assured them their job would be easy,” the owner said. “Nobody was going to pay more or give me a better deal.”
But Intrepid did line up a few other offers, some complete buyouts and others in which the business owners would sell a majority of their equity to another firm. Ultimately, the company settled on a dividend recap deal with a private equity group.
The company borrowed about $25 million from the private equity group and used that money to pay out a dividend. In exchange, the private equity firm will get interest payments for the next several years and the opportunity to buy a minority stake in the company.
So the owner gets to keep at least 70 percent of the company, plus the $25 million.
It’s an expensive loan – the interest rate is 10 percent – but the company gets to make interest-only payments on the debt.
The owner said that’s a good deal for him because the company is still growing and might sell in a few years for much more than the $40 million its competitor offered. At the same time, if the company struggles or busts, the cash he took out in this deal gives him a nice nest egg.
Essentially, he’s wagering that he can grow the company enough over the next few years that when he sells out, he can get enough to pay off the debt and have enough left over for yet another payout.
“As long as we believe we’re going to continue to grow, it’s a good deal,” the owner said.
For most business owners taking debt-funded dividends, diversification is the goal – and potentially a good move, said Morgan Stanley’s Munster.
“When you walk through a business owner’s balance sheet you see they have $75 million in assets, and $70 million of that is their business,” he said. “They see that if anything goes wrong, their whole net worth goes with it. In the vast majority of situations, folks doing this are reducing risk by diversifying.”
Still, there are downsides, both for the business owner and the business.
For starters, depending on how a deal is structured, business owners will pay capital gains taxes on their dividends, then their businesses will have to pay taxes on some of the debt service. Interest payments are tax deductible, but principle payments aren’t.
“You end up getting taxed twice,” Munster said. “That’s been a sticking point for business owners.”
One way around that higher tax bill is to take out an interest-only loan. That type of deal is particularly popular, often offered by private equity firms, business development companies and other private financiers.
But an interest-only loan has to be paid off eventually, meaning a business either has to be prepared to write a check for millions of dollars all at once or to refinance the debt.
Lenders are also taking big risks, structuring deals in ways that are friendly to borrowers but that could blow up.
Most loans, whether from a bank or private lender, would require a borrowing company to check in every quarter and show it’s meeting goals for revenue and earnings. But in many cases, lenders are scaling back those requirements, sometimes checking in annually.
And that’s dangerous, Bernath said, because it can mean a lender doesn’t know there’s a problem until months after it comes up.
“It takes longer to recognize a company is at risk,” he said. “When you remove those provisions, sometimes things can go bad to the point where you’re not able to deal with it except in a difficult work-out.”
But for now, interest rates are low, borrowers are paying their debts and investment bankers said business owners will keep getting approached with offers of easy money. Bernath described the current environment as a cyclical high that will eventually ebb. And he thinks – and hopes – lenders will prove to have been more cautious this time around than they were in the days of easy money before the recession.
“There’s never been a better time to be a consumer of capital,” he said. “But this environment is not going to last forever. Hopefully, it doesn’t end like last time.”
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