What Is Recapitalization?

Recapitalization is the process of restructuring a company's debt and equity mixture, often to make a company's capital structure more stable.

The process essentially involves the exchange of one form of financing for another, such as removing preferred shares from the company's capital structure and replacing them with bonds.

Understanding Recapitalization

Recapitalization is basically the strategy a company uses to improve its financial stability or overhaul its financial structure. In order to accomplish this, the company must change its debt to equity ratio. This is done by adding more debt or more equity to its capital.

There are many reasons why a company may consider to undergo recapitalization including:

  • When share prices fall
  • To protect itself against a hostile takeover attempt
  • To reduce financial obligations and minimize taxes
  • To provide venture capitalists with an exit strategy
  • Bankruptcy

When a company's debt decreases in proportion to its equity, it has lower leverage. Its earnings per share (EPS) should decrease following the change. But its shares would be incrementally less risky since the company has fewer debt obligations, which require interest payments and return of principal upon maturity. Without the requirements of debt, the company can return more of its profits and cash to shareholders.

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Recapitalization

Reasons to Consider Recapitalization

There are several reasons that motivate a company to recapitalize. A company may decide to use it as a strategy to defend itself against a hostile takeover. The target company's management may decide to issue more debt to make it less attractive to the potential acquirer.

Another reason may be to reduce its financial obligations. Higher debt levels compared to equity means higher interest payments. By trading in debt for equity, the company is able to reduce the level of debt and, therefore, the amount of interest it pays to its creditors. This, in turn, improves the company's overall financial wellbeing.

Furthermore, it's a viable strategy to help keep share prices from dropping. If a company finds the value of its shares is on the decline, it may decide to swap equity for debt to push the stock price back up.

Some companies may also use recapitalization as a way to minimize their tax payments, to implement an exit strategy for venture capitalists, or to reorganize themselves during a bankruptcy. Companies often use this as a way to diversify their debt-to-equity ratio to improve liquidity.

Key Takeaways

  • Recapitalization is the restructuring of a company's debt and equity ratio.
  • The purpose of recapitalization is to stabilize a company's capital structure.
  • Some of the reasons a company may consider recapitalization include a drop in its share prices, defense against a hostile takeover, or bankruptcy.

Types of Recapitalization

Companies can swap debt for equity or vice versa for a number of reasons. A good example of equity replacing debt in the capital structure is when a company issues stock in order to buy back debt securities, increasing its proportion of equity capital as compared to its debt capital. This increases its proportion of equity capital as compared to its debt capital. This is called an equity recapitalization.

Debt investors require routine payments and a return of principal upon maturity, so a swap of debt for equity helps a company maintain its cash and use the cash generated from operations for business purposes, reinvestment or capital returns to equity holders.

On the other hand, a company may issue debt and use the cash to buy back shares and/or issue dividends, effectively recapitalizing the company by increasing the proportion of debt in the capital structure. Another benefit of taking on more debt is that interest payments are tax deductible, while dividends are not. By paying interest on debt securities, a company can decrease its tax bill and increase the amount of capital returned in total to both debt and equity investors.

Governments also partake in a mass recapitalization of their countries' banking sectors during times of financial crisis and when the solvency and liquidity of banks and the greater financial system come into question. For example, the U.S. government recapitalized the country's banking sector with various forms of equity in order to keep the banks and the financial system solvent and maintain liquidity through the Troubled Asset Relief Program (TARP) in 2008.

[Important: Governments may buy back shares to get a controlling interest in a company important to a nation's economy through nationalization—another form of recapitalization.]