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Chapter 5 of 6 · 12 min

The dividend recap

Borrow against a business that has paid down debt, and send the cash to the sponsor early.

By the end of this chapter you can
  • Size a dividend from a recap to a new leverage multiple
  • Show why MOIC is unchanged while IRR rises
  • Work out the recap leverage that returns the whole equity check
  • Explain what a recap costs and who might object
1

The intuition

You bought a house with a mortgage and have paid a good part of it off, while the house has risen in value. You remortgage back up to a bigger loan and take the difference as cash. You have not made the house worth a cent more. You have moved some of the money you would get when you sell to today.

A dividend recap is exactly this, done to a portfolio company. The sponsor gets cash early, and money back early is worth more in IRR terms than the same money later.

The key idea

Dividend = new debt − debt still owed. Ignoring the extra interest, the dividend comes straight out of the exit check: total dollars are the same, so MOIC is unchanged, but they arrive sooner, so IRR rises.

2

Why it works

  • The conventions here: a five-year hold, a fixed amount of debt repaid each year, a recap in year 2 or 3 to a stated multiple of that year's EBITDA. The recap debt is repaid out of the exit proceeds and its interest is ignored.
  • The dividend = recap multiple × that year's EBITDA − the debt still owed. It is bigger when the business has grown and paid debt down.
  • MOIC is unchanged. Every dollar paid out early is a dollar more debt at exit, so dividend + smaller exit check = the original exit check.
  • IRR rises because the same dollars arrive earlier. With a cash flow in the middle, the IRR is solved from the dated flows rather than read off a root.
  • It takes risk off the table. Once the dividend has returned the original check, the rest of the hold is played with profit, not capital. It also returns cash to LPs early, which improves DPI.
  • The cost, ignored here: interest on the new debt reduces the exit check and so the MOIC, and a more levered company is more fragile. Existing lenders' covenants limit how much can be paid out.
$400M of equity in; without a recap, $1,000M at the year-5 exit. A year-2 recap pays $200M
No recap: MOIC 1,000 ÷ 4002.5x
No recap: IRR 2.5^(1/5) − 120.1%
With recap: exit check 1,000 − 200800
With recap: MOIC (200 + 800) ÷ 4002.5x
With recap: IRR solving −400 + 200 ÷ (1 + r)² + 800 ÷ (1 + r)⁵ = 024.2%

Same dollars, same multiple; four points more IRR for having half the check back in year 2.

3

The formulas

Debt in year k = entry debt − k × annual repayment

What the business still owes at the recap.

Dividend = recap multiple × EBITDA in year k − debt in year k

New loan less the old one.

Exit equity with recap = exit equity without − dividend

The recap debt is repaid at exit.

MOIC with recap = (dividend + exit equity with recap) ÷ entry equity = unchanged

Same dollars.

IRR solves −equity + dividend ÷ (1 + r)^k + exit equity ÷ (1 + r)^5 = 0

Earlier dollars, higher rate.

Recap multiple to return the check = (debt in year k + entry equity) ÷ EBITDA in year k

Run it backwards.

4

Worked example

Debt still owed at the recap, EBITDA that year, the new loan, and the difference is the dividend.

Drawing the numbers…
5

See it move

Same company and the same recap. Here only the exit moves: change the exit multiple and see what the recap has already locked in. Press New company and numbers for a different recap.

Drawing the numbers…
Try this
  • Move the exit multiple. The dividend does not change, because it was paid years before the exit, so the whole change lands on the exit check.
  • Whatever you set, the dividend and the exit check with the recap add up to the exit check without it, so the MOIC is the same both ways.
  • Watch the IRR bars as the exit multiple moves. The recap lifts the IRR on every setting, but by how much depends on how big the dividend is next to the exit check.
  • Lower the exit multiple as far as it goes. The exit check shrinks, but the dividend is already banked: that is the de-risking sponsors want from a recap.
6

Run it backwards

Same company, reversed: the sponsor wants the recap to hand back its entire equity check. How far must the business be re-levered?

Drawing the numbers…

The new loan has to repay the debt still owed and pay out the whole check. Add the two, and divide by EBITDA in the recap year to express it as leverage.

Then compare it with the leverage at entry. If the answer is well above it, lenders are unlikely to agree, and a partial recap is the realistic outcome.

7

Traps

Saying a recap raises MOIC.
Ignoring interest, it moves dollars earlier and takes the same amount off the exit. MOIC is unchanged; only IRR rises. With interest, MOIC actually falls slightly.
Sizing the dividend as the whole new loan.
The new loan first repays the debt still owed. Only the rest is paid out.
Using the entry EBITDA for the recap.
Lenders lend on EBITDA at the time of the recap, which has grown since entry.
Reading the IRR off MOIC^(1/n).
With a dividend in the middle, the root formula does not apply. Solve for the rate that sets the dated cash flows to zero.
Treating a recap as free money.
The company carries more debt for the rest of the hold, pays more interest, and has less room if trading turns. Lenders and management may both object.
8

Say it in the interview

The interviewer asks

“What is a dividend recap and what does it do to returns?”

Say yours out loud first, then compare.
9

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4
Drawing your questions…
Remember
  • Dividend = recap debt − debt still owed.
  • Ignoring interest, MOIC is unchanged; IRR rises.
  • Recap multiple to return the check = (debt owed + equity) ÷ EBITDA that year.
  • It de-risks the deal, at the cost of a more levered company.