Just To Recap

The world is divided between those who think that the leveraged debt market is overheated, and those who know it is.

And for both camps, as surely as the arrival of pumpkin pie mix on supermarket end caps heralds turkey day, the appearance of the ranks of dividend recaps on loan and high-yield shelves is a vivid sign of investor over-exuberance.

PE sponsors recapitalizing portfolio companies just to take out cash they had put into the original LBO were once features of a late-stage market. But the velocity of market cycles is such today that recaps occur at the beginning. It took six years after the dot com crash for leveraged wackiness to return. This round it’s taken six months.

Call it the First Law of Capital Markets Dynamics: “A general partner will act to return as much money to its limited partners as quickly as it can, until the market says it can’t.” And so far “the market” is saying, “Yes, you can.”

First, there’s the supply/demand thing: investors so desperate for yield – in the absence of new LBOs – they don’t want to get taken out of a decent asset they’re already in. Then there’s the pent-up realization thing: sponsors have been shut out for two years from exiting investments, so they need to show their limiteds some returns.

In the early stages of this recap mania – meaning last Tuesday – investors had three criteria to assess dividend deals: the sponsor leaves some skin in the game (i.e. doesn’t take out all their invested cash equity), total pro forma leverage is no higher than that of the original LBO, and the company is hitting its numbers.

HCA, the jumbo hospital operator, yesterday printed $1.525 billion in junk as part of a $2 billion dividend to its owners. According to the WSJ, it was HCA’s third dividend this year. Cash out? $4.25 billion. Original cash in? $5.5 billion. Still some skin left.

But what’s notable about this latest refund (the first two being funded with cash and RC borrowings) is that the bonds are at a newly created holding company. That means those investors will be subordinate to all other HCA debt. The issue still sold well, and the company’s announced 3Q numbers were up from last year.

Not everyone loves recaps. Here’s the founder of a top-tier PE fund: “It’s crazy to leverage up your company to do these,” he said. “At this point in the cycle you should conserve cash and borrowing capacity to pick off competitors and grow market share and shareholder value. When you do exit, you’ll deliver way better returns to your LPs.”

For all lenders’ angst, the real question is how will these recap credits actually perform over time? If the past is any predictor, they may do pretty well. According to LCD, defaults for vintage 2003-2007 recaps were lower, at 5.9%, than regular LBOs, at 7.4%.

Of course, piling on corporate debt for any reason in the face of an uncertain economic outlook may not be the wisest course of action. But in the meantime, as the Second Law of Private Equity Dynamics states: “Anything worth doing is worth overdoing.”

Randy Schwimmer is senior managing director and head of capital markets at Churchill Financial, as well as columnist for its weekly “On the Left” newsletter. Reach him at rschwimmer@churchillnet.com.