Private equity firms desperate for cash turn to a familiar trick

The rush into junk debt is letting buyout firms deliver payments to investors—and themselves—during a sharp slowdown in deals that is making it hard to sell portfolio companies. The transactions, which rely on low-rated debt, are known on Wall Street as dividend recapitalizations.

“It’s a way to return capital without selling the business," said J.W. Perry, who is head of the sponsor practice at Davis Polk and works with clients including private-equity firms Bain Capital and Madison Dearborn Partners.

Debt issued this year for such dividend payouts rose to $43 billion as of early August, according to data from PitchBook LCD. That is up from $7.4 billion for the same period in 2023 and nearly as high as 2021’s record pace, when debt was cheap and dealmaking rampant.

Dividend recaps let private-equity firms get money from existing portfolio companies without having to sell them.

Even with the recapitalizations, private-equity firms aren’t returning as much cash to investors as they would by selling companies. The rate at which capital is being returned to limited partners is the fourth lowest in the past 25 years, according to Raymond James.

Darius Craton, director at Raymond James’s private capital advisory group, said the distribution rate of money going back to these investors was 11.5% at the end of last year and is trending toward 12% so far this year. In 2021, the distribution rate was 31.3% according to data from Hamilton Lane Data via Cobalt.

“2023 really ended in lows we hadn’t seen since the great financial crisis," Craton said. “The data isn’t showing any improvement as of the second quarter, that we hoped to see."

Among the largest dividend recaps so far this year is a $2.7 billion recapitalization by auto-body repair center Caliber Collision, according to data from PitchBook LCD. The company is backed by investors including the private-equity firm Hellman & Friedman. A report from S&P Global Ratings said the money was used to pay existing debt and distribute a $1 billion dividend to its equity holders.

In March, rail and transportation services company Genesee & Wyoming completed a roughly $2.7 billion recapitalization. The company, backed by investors including Brookfield Infrastructure Partners, used the transaction to pay a $761 million dividend, according to S&P.

Some criticize dividend recaps, saying they weaken companies to the benefit of their investors. The avalanche of recapitalization deals is happening when debt is more expensive than in the past.

That has weighed on dealmaking, too, but there are signs the market is improving. U.S. private-equity deals—including exits, add-ons and purchases—are up some 10% at $281 billion as of early August, according to Dealogic. That is coming off deep lows in 2023.

Some of that resulted from leveraged loans becoming more accessible to firms, especially from traditional lenders such as banks.

Leveraged buyouts backed by private equity are up some 37%, according to Dealogic. As of early August, there have been $143.9 billion worth of leveraged buyouts, compared with $104.8 billion over the same time last year.

The leveraged loan market is a far cry from a few years ago, when many private-equity firms were looking to private lenders—and their expensive cash—to back their biggest buyouts.

When private-equity firms are ready to buy and sell companies on a grand scale again, industry watchers say, the loan market is ready, although there has recently been turbulence after volatility in the wider stock market.

“Right now I don’t think the debt markets would hold up anything," Perry said of dealmaking.

Write to Laura Cooper at laura.cooper@wsj.com