Private equity is a type of investment capital, where a firm, or group of high-net-worth individuals, invest in a company in return for an equity stake. This allows them to own part of the company and in many cases make decisions on the future of the company. Private equity is limited to private companies, hence the name. It does not apply to publicly traded companies whose stock is listed on an exchange. Those companies have already raised investment capital by going public and listing their shares.

However, private equity does also refer to firms or individuals that purchase large amounts of a public company's shares to achieve majority ownership and then take that public company private. When the public company becomes private, it is delisted from a stock exchange. The goal is always to gain influence and control over a company, make adjustments, whether managerial or operational, with the intent to make the company a better performing one, resulting in stronger profits and high returns for the investors.

Part of the returns for investors in private equity is through receiving dividends, much like shareholders of a public company do. This process is known as dividend recapitalization and involves the process of raising debt to pay private equity shareholders a dividend. Dividend recapitalization is a way for investors to receive a return without having to sell their shares but can often be detrimental to the firm as taking on more debt is a risky maneuver if the company does not have a strategy in which to pay it back.

For example, Petco was taken private (for the first time) for $600 million by Texas Pacific Group in 2000. Previously, Petco had $90 million in long-term debt. Two years later when Petco went public again, it was saddled with $400 million in long-term debt (the company went private again in 2006). It begged the question of how the company's debt level could have grown so significantly in only two years.

Dividend Recapitalization

Dividend recapitalization pertains to a private company that takes on increased debt in order to pay a special dividend to private investors or shareholders. Dividend recapitalizations are very popular. The problem is that they only benefit a select few while adding debt to a company. This leads to dangerous territory because capital is being used to pay this special dividend as opposed to growing the actual business.

If the economy goes into recession (or worse), the increased debt will be nearly impossible to pay back. This could potentially lead a company to bankruptcy. If creditors must be repaid and rampant growth isn’t a factor, a company will need to lay off employees, cut pay, close underperforming locations, or find other ways to free up cash in order to pay off the debt. Even if the company isn't faced with bankruptcy, it will be headed in the wrong direction.

Unfortunately, when it comes to private companies, there is no way of knowing which ones are overleveraged. Bankruptcies can come out of nowhere. While it’s easy to see which public companies are overleveraged due to required transparency by the Securities and Exchange Commission (SEC), you can also see which companies are likely to have a sustainable dividend or dividend capable of growing.

Getting back to the Petco example, this was done for dividend recapitalization purposes, so private equity sponsors and management teams could recoup their investments. There are many other examples of this occurring in private equity firms.

Real World Examples

BJ’s Wholesale Club was taken private by Leonard Green and CVC Capital for $2.8 billion in 2011. Leonard Green and CVC Capital demanded $643 million for a dividend payment. Since BJ’s didn’t have $643 million available, it had to take out a loan.

In 2009, Bankrate was taken private by Apax Partners for $570 million. Prior to this event, Bankrate had no long-term debt. One year after going private, it had $220 million in long-term debt.

In 2008, Restoration Hardware Holdings, Inc. (RH) was bought by Catterton Partners for $267 million. At the time it had $103 million in long-term debt. When Restoration Hardware had an initial public offering (IPO) in 2012, it had $144 million in long-term debt.

The Bottom Line

Private equity isn’t always what it’s cracked up to be unless you’re one of the select few being rewarded. Even if you fit into that category, there’s sometimes a moral issue related to what’s really best for the company.

Dividend recapitalizations are a form of private equity dividend that is achieved by taking on additional loans just to pay select shareholders so that they can earn a pre-sale profit. This can lead to an overleveraged situation and increased potential for bankruptcy.