A dividend recapitalization involves a company incurring additional debt in order to pay a special dividend to shareholders. The company may incur additional debt by issuing bonds to private investors or undertaking a new loan by accessing the syndicated leverage loan markets.

Traditionally, dividends are paid to a company’s shareholders out of a company’s profits. Typical dividends are usually paid on a quarterly basis or as determined by the board of directors. The amount of the dividend issued is based on a percentage of the company’s retained earnings for the quarter. The dividend can be paid in the form of cash or additional shares of the company. A traditional dividend payment can provide shareholders with a steady income stream in return for being long-term investors in the company.

A dividend recapitalization is unique. Dividend recapitalizations are funded by incurring additional debt, not from retained earnings like a traditional dividend. The additional debt incurred is often in the form of a loan taken out explicitly for the purpose of paying a special dividend to shareholders.

Dividend recapitalizations, also known as dividend recaps or leveraged dividends, are often deployed by private equity firms seeking to leverage liquidity from their portfolio companies. The special cash dividend payment is used to incentivize the private equity fund investors. It is a way for a private equity firm to return cash to its investors when an exit opportunity for the portfolio company, such as an IPO or sale, is not imminent. The private equity sponsor may use its influence or control over the portfolio company in order to get the portfolio company to undertake a dividend recap.

A company can be exposed to legal risks as a result of its decision to undertake dividend recaps. After the dividend is issued, the company is even more highly leveraged than before. In the event of an economic downturn, more of the company’s future cash flows will have to be diverted to principal and interest payments on its outstanding loans. This can leave the company particularly vulnerable to unexpected events. Lawsuits have been brought against companies in cases where a company went bankrupt following a dividend recap.

Additionally, a significant portion of the special dividend payment may go to the private equity fund investors. This can create a potential conflict of interest. Lawsuits have been brought against private equity sponsors under a theory that the issuance of the special dividend constituted a fraudulent transfer.

As an example of a recent dividend recapitalization, the railroad company Genesee & Wyoming completed a $2.7 dividend recap. Of this loan amount, approximately $761 million was issued as a special dividend to investors. Following the dividend recap, the company’s credit rating was downgraded. The increased leverage was partly to blame for the credit rating downgrade.

While this technique is more advantageous when interest rates are lower, dividend recaps have remained popular in the past couple years despite the high interest environment. This is attributable in part to a weak initial public offering (IPO) market. Other good exit opportunities, such as a sale to a peer company, have also been difficult to find in recent years. Companies and private equity sponsors considering a dividend recap should carefully weigh the potential risks against the benefits.