When the economy struggles, businesses typically hunker down and preserve cash by cutting spending and dividends. During the Covid-19 slowdown, companies controlled by private-equity firms have often gone the other way, borrowing heavily to pay big dividends to their owners.
The payouts boost returns for private-equity firms but can load their companies’ balance sheets with heavy debt at a precarious moment. The maneuvers can leave companies in weaker financial shape, while helping private-equity firms lock in gains, often a few years after their initial investments.
The amount of issued debt tied to such payouts, including both loans and bonds, grew to more than $29 billion this year, up more than 25% from 2019, according to S&P Global Market Intelligence’s LCD. Of that, loan volumes have grown well over 40% while bonds have fallen.
The payouts, known as dividend recapitalizations, are striking considering the pandemic’s economic disruption. By comparison, during the last recession, in 2008-09, such activity nearly dried up, the data shows.
One reason dividends fell so much in the last downturn is lenders grew cautious and wouldn’t lend to companies already considered to be risky. This time, near-zero interest rates and robust government buying of corporate bonds have pushed investors to take more risk to get a decent return.
Private-equity firms ranging from giants such as
Blackstone Group Inc.
& Co. to smaller players like Clearlake Capital Group and Leonard Green & Partners have capitalized on the situation.
Wheel Pros LLC, which sells splashy wheels for souped-up sports cars and trucks, spotlights the risks. The Colorado company’s wheels can sell for hundreds of dollars apiece, yet Wheel Pros managed to deliver stronger-than-expected performance when Covid-19 struck, driven in part by the government stimulus efforts and stay-at-home restrictions that made it tougher for people to spend disposable income, according to Moody’s Investors Service.
Normally it can be hard to sell fancy wheels in recessions. Adding to Wheel Pros’ risk is a heavy debt load, which even before the pandemic put its credit in high-risk territory. Yet the company took out more debt this fall, in part to fund what Moody’s said would be a $145 million investor dividend. The ratings firm noted the aggressive financial moves were challenging Wheel Pros’ credit standing, although it has held off downgrading Wheel Pros’ rating.
“Wheel Pros’ demand remains vulnerable in a prolonged economic downturn,” says Moody’s.
A key beneficiary of Wheel Pros’ debt was its owner, Clearlake Capital—a California private-equity firm that says it manages around $25 billion of assets. The debt-funded dividend would help to shield Clearlake from possible losses if Wheel Pros fell into trouble.
Clearlake and Wheel Pros declined to comment.
The aggressive use of debt at companies like Wheel Pros is part of private-equity firms’ playbooks. It is one reason they grew from a niche corner of Wall Street to investing leviathans over the last few decades. Private-equity firms managed more than $4.7 trillion of assets as of June of this year, up from less than $1.5 trillion before the financial crisis. Their investments touch every corner of American life, from rental homes to retailers to hospitals on the front-lines of the pandemic.
If the added debt causes Wheel Pros or other companies to struggle, it could put the private-equity industry under a regulatory spotlight in Washington. President-elect
has pledged a tougher line on Wall Street and the progressive wing of the Democratic Party is eager to crack down on private equity.
A key concern among some people who follow the sector is when such debt-funded dividend deals go sour, workers, company suppliers and other stakeholders suffer while investors have already locked in gains. Massachusetts Democratic Sen.
previously introduced legislation that would ban private-equity firms from receiving dividends within the first two years of buying a company.
Many in the industry believe a crackdown is unlikely. “We’re predicting a pretty moderate approach to regulation,” said
Apollo Global Management Inc.,
in a recent virtual conference.
The loans that funded the recent dividend payments reflect a view by creditors that the economy will likely rebound strongly once Covid-19 is controlled. Until then, the hope is that companies will be able to generate enough cash to avoid defaulting.
Several of the large dividends this year came from technology-focused firms that have generally fared better through the downturn compared with companies in such industries as retail and travel. These include KKR receiving a $560 million dividend in July from debt taken by back-office tech provider Epicor Software Corp. Blackstone similarly took a debt-funded payout from the company that runs the Bumble dating app.
“Dividend recaps make sense when the company has demonstrated the consistent cash flow and financial health to take on more debt,” said Epicor CEO
in a written response to questions.
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Tacala Companies says it owns more than 300 Taco Bell restaurants across the Southeast and in Texas. While drive-through dining helped Tacala escape the fates of many restaurant owners in the pandemic, credit analysts have noted the company has been carrying a heavy debt burden.
Yet as Covid-19 cases rose this fall, Tacala borrowed more to fund a $120 million dividend, according to Moody’s. The company is backed by Altamont Capital Partners of Palo Alto, Calif.
Altamont and Tacala didn’t respond to requests for comment on the decision to do the dividend now.
The U.S. so far hasn’t witnessed the surge of corporate defaults that some economists feared this spring. But specific sectors—most notably retail—have exposed the risks of such large debt-funded dividend payments. J.Crew Group Inc. was one notable retailer whose dividends to private-equity backers contributed to an unsustainable debt load that forced it into bankruptcy after Covid-19 hit.
Some of the most controversial debt-financed dividend payouts in recent years have been by Prospect Medical Holdings Inc., a hospital operator majority-owned by private-equity firm Leonard Green.
Prospect manages 17 hospitals across the U.S., many of which are classified as safety-net facilities that treat poor and vulnerable patients. Over the last decade, Prospect paid its shareholders, the biggest of which is Leonard Green, more than $500 million in dividends from these hospitals, while loading Prospect’s balance sheet with new debt, according to a debt prospectus and Moody’s.
After the company sought to buy two hospitals in Rhode Island in 2013, state officials requested that Prospect confirm it had no plans to pay further dividends to its shareholders after a $100 million dividend it had paid in 2012. Prospect responded that it didn’t, according to correspondence between the state and the company viewed by the Journal.
A few years after receiving clearance to buy the hospitals, Prospect agreed to pay an over $400 million debt-funded dividend to shareholders including Leonard Green.
The private-equity firm is looking to now sell Prospect to members of the hospital’s management, a deal that has so far failed to win approval from Rhode Island, pending a review of Prospect’s activities by the state. The review has been examining the dividends paid to Leonard Green and other financial information, according to a public disclosure.
Former employees say the hospital chain has suffered under Leonard Green. Prospect closed one hospital in Texas late last year, and multiple Democratic members of Congress have said in recent letters to Leonard Green that the dividends had diverted money away from patient care.
Leonard Green has denied this, saying Prospect is well-capitalized for its operations. In response to the letters, the firm says it has worked hard to ease Prospect’s debt load in recent years.
If these payouts become political issues, the trick for policy makers will be figuring out ways to spread private equity’s benefits more equitably without undercutting the industry, said
Steven J. Davis,
a University of Chicago Booth School of Business professor who has studied the social impacts of private-equity buyouts.
“There are benefits from private equity for society as a whole, and we don’t want to throw that away,” he said, noting the sector’s role in boosting productivity. “You don’t want to kill that goose. You might want to think about how to make the goose behave in a way that’s somewhat more advantageous to society at large.”
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