What is leverage recapitalization?
A leveraged recapitalization is a business financing transaction in which a company changes its capitalization structure by replacing the majority of its equity with a set of debt securities made up of both senior bank debts and subordinated debts. A leveraged recapitalization is also called a leveraged recapitalization. In other words, the company will borrow money to buy back previously issued shares and reduce the amount of equity in its capital structure. Senior managers / employees may receive additional equity capital to align their interests with bondholders and shareholders.
Usually, a leveraged recapitalization is used to prepare the business for a period of growth, because a capitalization structure that uses debt is more advantageous for a company during periods of growth. Leveraged recapitalizations are also popular during periods of low interest rates, as low interest rates can make borrowing money to pay down debt or equity more affordable for businesses.
Leverage recapitalizations are different from leverage recapitalizations. In dividend recapitalizations, the capital structure remains unchanged because only a special dividend is paid.
Understanding leverage recapitalization
Leverage recapitalizations have a similar structure to that used in leveraged buyouts (LBOs) in that they significantly increase leverage. But unlike LBOs, they can remain listed on the stock market. Shareholders are less likely to be affected by leveraged recapitalizations than new share issues, as the issue of new shares can dilute the value of existing shares, unlike borrowing money. For this reason, leveraged recapitalizations are viewed more favorably by shareholders.
They are sometimes used by private equity firms to withdraw part of their investments early or as a source of refinancing. And they have similar impacts to leveraged buyouts, except in the case of dividend recapitalizations. Using debt can provide a tax shield, which could outweigh additional interest charges. This is called the Modigliani-Miller theorem, which shows that debt provides tax benefits that are not accessible through equity. And leveraged recaps can increase earnings per share (EPS), return on equity and the price-to-pound ratio. Borrowing money to pay off older debts or to buy back stocks also helps businesses avoid the opportunity cost of doing so with profits.
Like LBOs, leveraged recapitalizations encourage management to be more disciplined and to improve operational efficiency, in order to cope with higher interest and principal payments. They are often accompanied by a restructuring during which the company sells redundant assets or which no longer correspond to a strategy in order to reduce its debt. However, the risk is that an extremely high leverage could lead a company to lose its strategic focus and become much more vulnerable to unexpected shocks or a recession. If the current debt environment changes, an increase in interest expense could threaten the viability of the business.
History of leveraged recapitalization
Leverage recapitalizations were particularly popular in the late 1980s, when the vast majority of them were used as a defense against takeovers in mature industries that do not require significant spending on continuous fixed assets to remain competitive. The increase in balance sheet debt, and therefore the leverage of a company, acts as a repulsive protection against sharks against hostile takeovers by looters.