It’s always exciting news when a public company is taken private, but in some cases there’s more to the story. 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 2006). This is only one example of many and the private equity firms that take companies private sometimes have one specific goal in mind. (For more, see: What Is Private Equity?)

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. At the moment, 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 (negatively impacts customers service), 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. (For more, see: What Kinds of Private Equity Investments Are Out There?)

Unfortunately when it comes to private companies, there is no way of knowing which ones are overleveraged. Bankruptcies can come out of nowhere. While I do think the stock market has been artificially propped up due to accommodative monetary policies, the majority of public companies will take a hit and then fight their way back. There will be bankruptcies, but not nearly as many as in the private market. Plus, it’s easy to see which public companies are overleveraged thanks to required transparency. You can also see which companies are likely to have a sustainable dividend or dividend capable of growing. (For more, see: An Overview of Corporate Bankruptcy.)

Getting back to that 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.

Other 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, Inc. (RATE) 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. Bankrate has since gone public again. It currently has $297.30 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. It currently has $436.18 million in long-term debt. (For more, see: Restoration Hardware: Has It Come too Far too Fast?)

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 can lead to an overleveraged situation and increased potential for bankruptcy. At the time of this writing, private equity as a whole is in extreme bubble territory. Consider avoiding. (For more, see: Why Buffett Is Right to Avoid Buying Private-Equity-Owned Businesses.)

Dan Moskowitz does now own shares in RATE or RH.