Pace of Dividend Recaps to Drop in ’13

The number of dividend recaps may have soared in fourth quarter but don’t expect that to continue, according to Moody’s Investors Service.

Moody’s expects the pace of dividend recaps to slow this year. There were about 100 debt-financed dividend recaps in 2012, worth nearly $32 billion. But more than half, or 52, occurred in fourth quarter alone and were valued at nearly $15 billion, Moody’s says. This is triple the average pace of dividend recaps that took place during the first three quarters of 2012, Moody’s says. (There were 49 dividend recaps from Q1 to Q3 worth $16.8 billion, Moody’s says.)

It’s not clear how many dividend recaps we’ve had so far in 2013, but Moody’s expects the number to drop. “Dividend recaps will remain a viable exit strategy but there won’t be the  frantic pace we saw in fourth quarter,” says Lenny Ajzenman, a Moody’s senior vice president

Tax changes is the main reason for the slowdown. PE firms rushed to take dividend recaps in fourth quarter amid concern fiscal cliff negotiations would boost the dividend tax rate. Those fears turned out to be true. The fiscal cliff compromise, which was reached on New Year’s Day, did increase the dividend tax rate to 23.8% from 15% (this includes a 3.8% boost from the Affordable Care Act that was passed in 2010), Moody’s says. With the resolution, the pace of dividend recaps should decline this year, Ajzenman says.

Moody’s also expects M&A to get a boost in 2013. Strategic have lots of cash, while financial sponsors have much dry power to put to work, Moody’s says. International issues, including Italy’s recent election, as well as current U.S. budget negotiations are potential wild cards in any forecast, Ajzenman says. “Those are all risks out there that could affect the credit markets and the number of deals getting done,” he says.

Another harbinger of potential doom? PIK toggle notes reemerged in fourth quarter. Such debt was popular during the private equity boom time of 2005 to 2007. PIK toggle notes allow companies to pay interest with more debt rather than cash, Moody’s says. Nearly 20% of dividend recaps in fourth quarter were funded using PIK toggle notes in Q4, Moody’s says.

PIK toggle notes can be an effective way for PE firms to extract dividends or fund LBOs, Moody’s says. But they’re very risky. PIK toggle notes are issued by a holding company and don’t have guarantees from the operating company, says Ajzenman. PIK notes are considered structurally subordinated to the debt of the operating company. “In a default scenario they get paid last, after all the debt at the operating company is paid,” he says.

We’ve already seen a PIK note offering this year. Burlington Holdings, parent of retailer Burlington Coat Factory Warehouse Corp., is offering $350 million of senior unsecured PIK toggle notes due 2018. Bain acquired Burlington Coat Factory, which sells coats and women’s sportswear, in 2006 for $2.06 billion.

Proceeds of Burlington’s PIK loan will be used to pay a dividend to Bain, while proforma debt to EBITDA jumps to about 6.7x, Moody’s says.

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