Data shows that private equity funds are increasingly pushing their portfolio companies to take on more debt to return cash to investors.
This comes as the typical ways to monetize private equity investments – selling shares in companies through IPOs or offloading them to other PE funds or buyers – have dried up in recent years.
While investors receive rewards, the practice of private equity sponsors adding more debt to companies, known as dividend recapitalization, risks weakening their ability to invest or survive future trading downturns.
Dividend roundup activity has surged since 2022, and Moody’s Ratings expects it to remain high in Europe, the Middle East and Africa as private equity firms look for ways to return money to investors while corporate sales and IPOs remain weak.
The rating agency estimates that private equity-owned companies in the EMEA region could take on an additional 41 billion euros ($46 billion) in debt before reaching leverage levels that would normally prompt a rating downgrade.
Exits remain “few”
New Moody’s analysis shows that this practice is still limited to the best-performing companies with the greatest capacity to take on new debt, and that this “significant leverage capacity” could support further increases in dividend collections.
Still, it does not address the exit backlog weighing on private equity. Funds now have to hold companies for much longer than the typical five to six years.
“The fundamental problem is that there are very few exits,” said Mayank Malik, an analyst at Moody’s. “Europe’s IPO market is depressed, and capital to fund strategic acquisitions by large companies has generally become much more expensive after the last rate hike cycle.” “In general, we are more focused on the impact of the general PE ecosystem on corporate credit quality, which is now one of the key transmission mechanisms.”
Moody’s said PE sponsors continue to be “disciplined” in selecting dividend roundup candidates, with the most active sectors being services, consumer products and manufacturing.
Malik noted that most of the dividend recaps involved companies that outperformed their original business plans, and that new debt typically returned leverage to initial levels without having a “material” impact on exit opportunities.
“But it is true that companies preparing for an IPO want to demonstrate a solid track record of deleveraging for several years before approaching the market,” he told CNBC via email.
“Certainly, there is a risk that if the IPO window unexpectedly opens, issuers that have recently wrapped up divs may not jump on the opportunity. Companies that have wrapped up divs are probably taking a positive view that the IPO market will close in the short term.”
Distributions to investors have decreased significantly in recent years. Citing data from PitchBook, Moody’s said private equity distributions have fallen from just over 30% of starting net asset value in 2022 to about 12% now.
“The risk is that if PE exit balances are prolonged, sponsors may start looking to monetize relatively weaker credit, which could lead to overall portfolio credit deterioration,” Malik added.
He said these risks are greater than they were a decade ago, in part because documentation has become “much more permissive” for issuers looking to raise additional debt.
Tight credit markets support overall outlook for now
Portfolio companies are typically financed through the broader syndicated loan market, where multiple investment banks band together to lend money to borrowers and spread risk. Alternatively, funds can be raised by issuing high-yield corporate bonds or borrowing private credit.
Sunaina Sinha Haldea, global head of private capital advisory at Raymond James, said there was still “meaningful headroom” to fund recaps, highlighting how tight spreads and a lack of supply of new loans were supporting appetite.
“While supply could tighten due to weaker earnings, widening spreads, or investor exits, a recovery in acquisition funding will give lenders more options for financing shareholder dividends,” he said.
Haldea noted that dividend recapping would provide liquidity and ultimately reduce selling pressure without resolving the valuation gap.
“Investors will get some cash back, but the assets remain in the fund and still need an ultimate buyer,” Haldea told CNBC in an email.
“If earnings growth is creating true borrowing capacity, then a dividend package need not prevent an exit, but borrowing against expected growth is a different proposition. More debt means less financial flexibility, and even at the same enterprise value, shareholders will be left with less equity when the business is ultimately sold.”
