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Dividend Recaps Done by the Numbers

So you’re a business owner without a lot of debt who wants to get in on the dividend recap free-for-all? It might not be so easy.

Dividend recaps are providing pots of gold to business owners lucky enough to fit right into lenders’ glass slippers. But those don’t come in every company’s size.

And that’s the main difference between now and the sizzling market of a few years back. It’s still a party atmosphere for companies lucky enough to get past the velvet rope and activity is booming, but the guest list is more tightly enforced.

“In 2007, it almost didn’t matter what the company did,” said Noel Ryan, a managing director at Century City investment bank Houlihan Lokey. “You’ve got a more discriminating market these days. Attractive deals are going to be oversubscribed significantly and, in certain cases, benefit from more aggressive pricing and structure than we witnessed in 2007. But not every credit fits that bill, and the more marginal deals will see the risk reflected in higher pricing and more restrictive terms.”

For businesses that do make the grade, a few of their prospective money partners shared with the Business Journal some insight into what they look for in a company – and what might scare them away.

Number crunching

Most dividend recap lending is based on a financial metric called earnings before interest, taxes, depreciation and amortization, or Ebitda. It captures essentially how much profit a company makes in a vacuum, without loan payments or taxes. Lenders see Ebitda as a window into a business’ fundamental profitability – and more importantly, its cash flow.

The total amount of debt that banks and other lenders provide to companies for dividend recaps is almost always based on some multiple of Ebitda.

A company with Ebitda of more than about $20 million can get financing at up to six times that, or $120 million, in today’s climate. This is as aggressive as lenders have been since the halcyon days of 2007.

Because Ebitda is so critical, the first step for any company interested in doing this type of deal is to prepare their financial statements for intense scrutiny.

A West L.A. fund manager who has recently done dividend recaps both as a borrower and lender, and requested anonymity because he is in a quiet period while raising a fund, said lenders are turned off by Ebitda figures that seem overly tweaked or manufactured, as it’s harder to get a true handle on the business.

“Fewer add-backs or adjustments, that always helps with the lender,” he said. “They like to see clean Ebitda without much volatility.”

Lenders also want to see forecasts and, more importantly, make sure business owners can back them up. They want to know not only how much you think revenue will grow, but why it will grow that much.

“You’re going to need to have a pretty good idea as to the outlook for your business,” Ryan said, “People will want to understand the assumptions behind it.”

Model business

Financial firms also place a heavy emphasis on the business model when underwriting dividend recap loans. They need to have confidence that a company will bring in enough cash flow to service the new debt.

That’s why lenders prefer businesses without many capital expenditures, such as equipment maintenance, and with customers that pay upfront. For instance, the West L.A. fund manager said a company that provides security guards would be a good candidate for a dividend recap.

“You have thousands of security guards and you really don’t have any capital expenditures,” the manager said. “You’re paying your people every month and you’re getting paid every month, so you don’t have a bunch of receivables. That’s a nice, clean, cash-flowing, recurring business.”

He added that another red flag for lenders are companies that get the bulk of their revenue from just a handful of customers.

“If you sell one product to Wal-Mart that represents 50 percent of revenue, you’re never going to get six times,” he said.

On the other hand, consumer product companies with loyal brand followings are great candidates for a recap, he said, both because they have a broad customer base and because such companies are attractive buyout targets for larger companies. That adds an extra layer of security to the loan: Lenders don’t just want to make sure the company can service the debt, they also want to feel confident that there are buyers out there who will pay enough for the company to pay off the whole loan. With Ebitda multiples as high as they are, that has to be a big check.

“If you’re lending at six times, you’d like to believe there would be buyers for the company at least 10 times Ebitda,” the West L.A. manager said.

But he stressed that what’s most important are the basics: solid growth and low volatility.

“You don’t need to be growing at 20 percent,” he said. “You just need to show a stable, reasonable growth rate. That’s what lenders are looking for: stability and recurring stability.”

Capital partners

Once a good candidate for a recap has its finances in order, the next step is to find a lender.

That search used to begin and end at the local bank. Banks are still an option, but there are also business development companies, private funds that originate debt and a seemingly infinite number of alternative financiers. One of the consequences of tightened bank lending standards is that the market for unregulated lenders that are able to take on more risk has expanded. And the higher yields on some dividend recap deals make it a line of business they increasingly want to pursue.

Commercial banks generally can’t issue debt at more than four times Ebitda. Alternative lenders are there to make up the difference, offering debt beyond what banks offer, though they sometimes finance entire deals themselves.

In a one-stop scenario like that, an alternative lender might provide financing at six times of Ebitda at an interest rate somewhere between 7.5 percent and 9 percent.

Raising the same amount of money through a more traditional route involves getting two separate loans: the first for up to four times Ebitda in senior debt from a commercial bank at about 3.5 percent or 4 percent interest; the second for an additional one or two times Ebitda in junior debt from an alternative lender at upwards of 10 percent.

But higher multiples and easy terms have an obvious downside. As many Americans discovered after they maxed out home equity loans as the real estate market crashed, businesses are less able to withstand bumps in the road when a lot of their cash flow immediately goes into interest payments.

“Some people try to push the leverage multiple, but the vast majority do consider the fact that they’re potentially taking only part of the value off the table,” Houlihan’s Ryan said. “If they have a deal that’s too leveraged or too restrictive, and there is even a minor hiccup in the business, they’ve got a bigger problem.”

However, the people currently pushing the envelope are yield-hungry lenders, not greedy borrowers.

“It’s really been driven by the credit markets,” the West L.A. manager said. “They are as frothy and aggressive as they’ve been, definitely similar to 2007, maybe worse.”

Then again, it’s hard to blame business owners and equity sponsors for getting it while the getting is good.

“If the market’s willing to give you the money and is willing to provide liberal terms and attractive leverage,” Ryan asked, “why not take advantage of it?”

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