What is leveraged recapitalization?
A leveraged recapitalization is a corporate financing transaction in which a company changes its capitalization structure by replacing the majority of its capital with a bundle of debt securities consisting of senior bank debt and subordinated debt. A leveraged recapitalization is also known as a leveraged recapitalization. In other words, the company will borrow money to buy back shares that were previously issued and reduce the amount of capital in its capital structure. Senior managers / employees may receive additional capital, in order to align their interests with bondholders and shareholders.
Generally, a leveraged recapitalization is used to prepare the company for a growth period, as 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, as low interest rates can make borrowing money to pay off debt or stocks more affordable for businesses.
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 structure similar to that used in leveraged acquisitions (LBO), insofar as they significantly increase financial leverage. But unlike LBOs, they can remain publicly traded. Shareholders are less likely to be affected by leveraged recapitalizations compared to new share issues because issuing new shares can dilute the value of existing shares, while borrowing money does not. For this reason, shareholders view leveraged recapitalizations more favorably.
Sometimes they are used by private equity companies to get out of part 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 could outweigh the additional interest expense. This is known as the Modigliani-Miller theorem, which shows that debt provides tax benefits that cannot be accessed through equity. And leveraged recaps can increase earnings per share (EPS), return on equity, and price / book ratio. Borrowing money to pay off old debts or buy back shares also helps companies avoid the opportunity cost of doing so with the profits made.
Like LBOs, leveraged recapitalizations provide incentives for management to be more disciplined and improve operating efficiency to meet higher interest and principal payments. They are often accompanied by a restructuring, in which the company sells assets that are superfluous or no longer strategic to reduce debt. However, the danger is that extremely high leverage can cause a company to lose its strategic focus and become much more vulnerable to unexpected shocks or a recession. If the current debt environment changes, rising interest expenses could threaten business viability.
History of leveraged recapitalization
Leveraged recapitalizations were especially popular in the late 1980s, when the vast majority of them were used as an acquisition defense in mature industries that do not require substantial ongoing capital expenditures to remain competitive. Increasing debt on the balance sheet and thus leverage of a company acts as a shark-repellent shield against hostile takeovers by corporate raiders.