(Bloomberg) — Private equity firms are pushing for greater flexibility to give themselves payouts, even when they’re losing money.
The initial fine print on two recent leveraged finance deals would have obliged companies to pay their owners dividends even if their earnings start to slide, according to people familiar with the transaction. That was the case with the sponsors of auto glassmaker Belron International Ltd. this month, who paid themselves over €4.3 billion ($4.7 billion) out of a leveraged financing for almost twice that much. Owners of Italian ice cream maker Sammontana Italia SpA pushed for similar language.
Private equity shops have always borrowed to buy companies, with the idea that they increase their value and sell them at a profit three to five years down the road. Now they want to lever up firms regardless of performance, so they can get regular dividend checks — and benefit from other flexibilities.
Belron’s and Sammontana’s owners had to drop the provisions after investors balked, according to the people, asking not to be identified because the information is private. But it shows how far private equity firms are seeking to go while demand for their debt is rampant.
“There’s a lot of demand in the market, which is causing these kind of provisions to continue to appear despite the fact that people can see how damaging they can be,” said Sabrina Fox of Fox Legal Training, an expert on company loan documents. “It feels so incongruous given where we are with restructurings.”
Private equity firms have turned to debt-funded dividend payouts at a record pace this year to juice returns. It’s just one of the tactics they’ve adopted to ride out a slump in deal-making as the normal way of producing payouts — selling assets — has been crushed by high rates.
Investors balked at the latest move by private equity firms seeking carte blanche on dividend recap deals after years of watching their protections whittled away. On a scale of 1 to 5, with 5 indicating the weakest, covenants for bonds and loans have stayed near the weakest score for the past decade, according to Moody’s Ratings. Since dipping to a record low in 2022, the score has climbed but remains in the weakest category.
While defaults following debt-funded dividends remain scarce, according to a Moody’s report published Oct. 10, that’s due to the fact these deals are typically done by higher-rated companies. The ratings firm noted that PE-owned companies are more prone to downgrades, especially those that have borrowed to pay their owners.
“Dividend recaps are an aggressive financial policy which can result in rating downgrades because they tend to increase leverage and don’t contribute to a company’s growth,” the report stated.
Standard Docs
Under standard bond documentation, private equity sponsors can claim no more than 50% of a company’s profit after exceptional items for future payouts.
Sammontana’s owner Investindustrial wanted to ignore loss-making quarters when it calculated the size of future dividends, taking into account only profitable quarters, the people said.
“It does not make conceptual sense to use the highest Ebitda ever achieved to calculate ratios and basket sizes,” said Jennifer Pence, senior credit officer at Moody’s. “It means you could see a distressed borrower having the capacity to make payouts based on historic earnings.”
Belron’s owners including Clayton, Dubilier & Rice LLC and Hellman & Friedman LLC tried to include a so-called high-watermark Ebitda clause which would have allowed them to use the highest level of earnings to calculate dividends, the people said. Belgian holding company D’Ieteren Group also owns a 50% stake in Belron, and would have benefited from future payouts. Other owners include Singapore sovereign wealth fund GIC and BlackRock Inc.
Representatives at CD&R, GIC, Investindustrial, BlackRock, Belron, Hellman & Friedman all declined to comment. Representatives at D’Ieteren and Sammontana didn’t respond to requests for comment.
Representatives at BNP Paribas SA, which helped arrange the financings, declined to comment, as did those at JPMorgan Chase & Co., which managed Belron’s deal.
Such high-watermark clauses have also cropped up on recent deals in the US, with a similar result: last month they were dropped from financings for First Advantage Holdings LLC and Instructure Holdings.
Death by Paper Cuts
Investors have flocked to riskier debt to lock in relatively high yields that are set to fall as central banks embark on rate-cutting cycles. But with economic growth also set to slow, companies that have leveraged up will have smaller cash reserves to weather a slump in earnings.
“Investors have lots of money to deploy, and are keen to see new issues,” said Thomas Samson, a high-yield portfolio manager at Muzinich & Co. But when it comes to dividend recaps, he said “there remains some uncertainty about their long-term impact on the financial stability of issuers.”
Even though Belron’s sponsors withdrew the high-watermark clause, they won flexibility that would allow them to siphon off €2.5 billion of cash as soon as the deal closes barring a material event of default, according to Pence at Moody’s.
“It’s death by a thousand paper cuts,” Pence said. “There are so many holes in sponsor documents.”
–With assistance from Abhinav Ramnarayan and Eliza Ronalds-Hannon.
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