A “recap” or leveraged recapitalization in private equity-controlled companies is often defined as increasing the debt to equity ratio. Cash is generated during the lifetime of the investment while maintaining significant ownership in the portfolio company.
In a dividend recap, a financial sponsor takes over a company or restructures an already owned company. By arranging new senior bank debt and perhaps subordinated debt or mezzanine that replaces equity, the financial sponsor generates excess cash, which is then paid out as an extra dividend.
The financial sponsor can use this technique to boost its rate of return (i.e., IRR) due to higher leverage and the tax shield on interest expenses; however, such a strategy also increases risk. therefore, recapitalizations are very attractive for companies with positive future prospects.
Financial sponsors usually look for companies with long track records, constant or increasing revenues and earnings, as well as an optimistic forecast to limit their downside risk. The risk can be substantial, if interest rates change or the business environment becomes unfavorable.