What Is Leveraged Recapitalization?
A leveraged recapitalization is a corporate finance transaction in which a company changes its capitalization structure by replacing the majority of its equity with a package of debt securities consisting of both senior bank debt and subordinated debt. A leveraged recapitalization is also referred to as leveraged recap. In other words, the company will borrow money in order to buy back shares that were previously issued, and reduce the amount of equity in its capital structure. Senior managers/employees may receive additional equity, in order to align their interests with the bondholders and shareholders.
Usually, a leveraged recapitalization is used to prepare the company for a period of growth, since a capitalization structure that leverages debt is more beneficial to a company during growth periods. Leveraged recapitalizations are also popular during periods when interest rates are low since low interest rates can make borrowing money to pay off debt or equity more affordable for companies.
Leveraged recapitalizations differ from leveraged dividend recapitalizations. In dividend recapitalizations, the capital structure remains unchanged because only a special dividend is paid.
Understanding Leveraged Recapitalization
Leveraged recapitalizations have a similar structure to that employed in leveraged buyouts (LBO), to the extent that they significantly increase financial leverage. But unlike LBOs, they may remain publicly traded. Shareholders are less likely to be impacted by leveraged recapitalizations as compared to new stock issuances because issuing new stocks can dilute the value of existing shares, while borrowing money does not. For this reason, leveraged recapitalizations are looked upon more favorably by shareholders.
They are sometimes used by private equity firms to exit some of their investment early or as a source of refinancing. And they have similar impacts to leveraged buybacks unless they are dividend recapitalizations. Using debt can provide a tax shield—which might outweigh the extra interest expense. This is known as the Modigliani-Miller theorem, which shows that debt provides tax benefits not accessible via equity. And leveraged recaps can increase earnings per share (EPS), return on equity and the price to book ratio. Borrowing money to pay off older debts or buy back stock also helps companies avoid the opportunity cost of doing so with earned profits.
Like LBOs, leveraged recapitalizations provide incentives for management to be more disciplined and improve operational efficiency, in order to meet larger interest and principal payments. They are often are accompanied by a restructuring, in which the company sells off assets that are redundant or no longer a strategic fit in order to reduce debt. However, the danger is that extremely high leverage can lead a company to lose its strategic focus and become much more vulnerable to unexpected shocks or a recession. If the current debt environment changes, increased interest expenses could threaten corporate viability.
History of Leveraged Recapitalization
Leveraged recapitalizations were especially popular in the late 1980s when the vast majority of them were used as a takeover defense in mature industries that do not require substantial ongoing capital expenditures to remain competitive. Increasing the debt on the balance sheet, and thus a company’s leverage acts as a shark repellant protection from hostile takeovers by corporate raiders.