Fund managers are reluctantly buying up the debt being pumped out by companies to pay their private equity owners bumper dividends, as a lack of new loan supply and low yields limit investors’ choice of other attractive investments.
Buyout firms trying to raise cash from their investments have been turning to so-called dividend recapitalisations at a record rate. Such deals give them juicy cash payouts but are often unpopular with bond investors worried about the impact of the larger debt pile on the company’s financial health.
Last month Belron Group, which owns car windscreen repair companies in the US and UK, launched a dividend recap in which it would raise €8.1bn and pay a €4.4bn dividend, in the largest such deal on record, according to PitchBook LCD.
But even though the dividend nearly doubled Belron’s overall debt from less than €5bn to almost €9bn and led rating agencies Moody’s and S&P Global to downgrade Belron deep in to junk territory, the deal was still massively oversubscribed, with demand more than seven times higher than available debt.
“We all hate dividend recaps — as a bond manager, you just hate them,” said one investor who followed the deal and asked not to be named. “But that’s what the market is right now, and if I’m getting flows of capital, I’ve got to buy something, so I get over that.”
The deal highlights the dilemma facing many debt fund managers, who are wary of being disadvantaged by private equity firms keen to extract cash from their portfolio companies but, with debt markets so buoyant, are faced with a lack of attractive investment opportunities. US high yield credit spreads, the borrowing cost premium above Treasuries, fell below 3 per cent this month for the first time since the 2008 global financial crisis, according to data from the Federal Reserve Bank of St Louis.
Overall, net leveraged loan supply in September hit minus $6.2bn, meaning that more loans were being repaid than issued and marking the largest deficit since February 2022, according to Fitch. Investors, bankers and analysts expect dividend recaps to remain popular until supply recovers.
“The theme of dividend recaps in 2024 and 2025 will only get louder but investors continue to prove themselves very selective on credits,” said Chris Bonner, head of US leveraged finance capital markets at Goldman Sachs.
“The real question will be: are investors willing to capitulate and buy tougher [lower quality] credits, or are they still going to only focus their attention on up-in-quality names?”
The volume of leveraged loans backing dividend recaps hit a record of more than $17bn in September, and quarterly volumes are at their highest in three years. Refinancings accounted for more than 71 per cent of high-yield bond issuance from October 2023 to September 2024, the highest share in a 12-month period since at least 2016, according to LevFin Insights.
A recent study by Abhishek Bhardwaj, Abhinav Gupta and Sabrina Howell found that while dividend recaps increase the chance of a good outcome for a company’s owners, they make firms riskier and “raise the spectre of bad outcomes for workers”.
“You have an instant reaction to a dividend recap: it’s negative,” said one bond investor, adding that not every such transaction was a bad deal but that when it came to issuers, “you have to be careful in terms of who’s going to be more aggressive than others.”
Other investors believe that, as long as the company is healthy enough to take on the additional debt, then such deals are worth investing in.
“From our perspective, it’s a good deal,” said another bond manager, referring to the Belron deal. “Is it cheap? Probably not cheap — it’s fair value. But if you think about the economic backdrop we’re faced with today . . . you want to own steady, stable businesses with cash flow in this type of environment.”
A Moody’s report on Thursday found that, of 66 dividend paying companies it examined, only five suffered defaults. While “top private equity firms gorged on more debt” to fund dividends, “defaults following debt-funded dividend transactions remain scarce because these deals are typically done by higher-rated LBOs [leveraged buyouts],” it said.
Many buyout groups are turning to dividend recaps after struggling to return cash to their investors, because of the sluggish pace of mergers and acquisitions and the unappealing prospects presented by flotations, which are hindering them from leaving their investments.
The lack of available options for fund managers means the high demand for Belron’s debt is not surprising, even though the deal is “purely a way to return money to shareholders”, said Lyuba Petrova, head of North America leveraged finance at Fitch.
“Certainly, lenders can vote with their dollars whether they want to stay in the deal or not,” Petrova said. “But right now, there is a net negative supply.”
In September Focus Financial Partners — which, like Belron, is backed by Clayton, Dubilier & Rice — conducted the sixth-largest private equity-backed dividend recap on record, according to PitchBook. Investment firm 3i this year carried out its eighth dividend recap of Dutch retail Action, this time to pay itself a windfall of nearly €1.1bn.
Belron declined to comment. Clayton, Dubilier & Rice did not respond to a request for comment.
With interest rates on the way down and default rates set to remain low, dividend recaps are likely to continue, said investors. However, a sharp economic downturn could change that.
“Big picture, these types of activities are still pretty minor and pretty muted,” said Ashok Bhatia, co-chief investment officer of fixed income at Neuberger Berman. But “if growth slows significantly . . . that’s when the piper would have to get paid.”