In Newt Gingrich’s private equity nightmare, an evil PE firm comes to town, buys out a struggling company, and has the company take on a ton of debt.
Meanwhile the firm manages to use that debt to enrich itself and the company’s shareholders, and walks away scott-free when the over-levered company goes bankrupt.
We wanted to know exactly how that could go down, so we asked some people in the industry to explain to us how a PE firm could pay itself and a company’s shareholders even if the company is on the road to bankruptcy.
Turns out, unsurprisingly, that it isn’t as simple as Newt’s Nightmare.
See, anything a private equity firm does to a company is just one of many tools in its tool box. A firm decides what to do (which tool to use) based on the problem a company is having. Just as you wouldn’t put a screw into a wall using a chainsaw, a PE firm needs to select the right tool for the right situation.
That said, let’s go back to basics.
Sometimes, when a PE firm buys a company, it injects pure equity (cash) into it. Sometimes, though, it needs to borrow money to put into the company. That’s a leveraged recapitalization, and it means the company is about to take on some debt. That makes everything riskier, and depending on how much cash the company needs, it could be a significant amount of debt.
However, a PE firm has to make sure that the company can handle that risk — it creates models and metrics to do that. And it isn’t just the PE firm that does it either, the banks or investors that give the firm their loan must do their due diligence as well.
“I don’t know any responsible private equity firm that would initiate a leverage recap if it would put the company at risk,” says Michael Carrazza, CEO of PE Firm Solaia Capital Advisers, “market metrics put you in a safe range… of what a company can safely take on.”
The operative word there is “responsible” (see: Gordon Gekko).
There are nasty surprises that can put a fly in this ointment too. One industry member reminded us that in 2009, after the financial sector crashed, a lot of PE firms found that all of the sudden companies also couldn’t pay down their debt. It was due to an unforeseen macro risk.
But what about when PE firms pay themselves and shareholders while a company is still deeply in debt? Why would they do it?
Let’s answer the second question first, PE firms keep hold on to some debt — keep the company they bought leveraged — because the interest rate on that debt is tax deduct able.
Now for the first question —PE firms pay out a company’s share holders with additional debt when a company is doing well but is not ready for sale. This move is called a dividend recapitalization (dividend recap). At this point, ideally, the company has debt, but it’s also taking in enough revenue to pay the interest on that debt along with paying investors.
Here’s how they get it done — remember, this is all on a case by case basis though.
First, if the PE firm doesn’t own the company fully, they will go to whoever is operating governance (board of directors or what have you) and pitch the dividend recap. They need to show that the company can take on this additional debt and still stay healthy.
If the board approves the dividend recap then the firm still needs to go to ratings agencies and make sure that the company’s rating will stay the same. If the rating goes down, then the company’s interest payments will go up, and the deal will be riskier or, frankly impossible.
If the ratings agencies give the PE firm the go ahead, then its time to approach the lenders (banks or investors) and see what kind of leverage the company can get. All of this means putting together a deal with all the bells and whistles — covenants, restrictions and limitations. Remember, if the lenders aren’t happy with the potential aftermath of a deal, they simply won’t accept the terms.
Your lenders may want a high yield note or a term loan — again, this all depends on the deal. But the bottom line here is that a PE firm doesn’t just say, “hey guys it’s time for a pay out” and BOOM it’s free money and cash all around. There are checks and balances.
And there’s also risk. The macro economic climate can turn on a company. Innovation can make a company’s product irrelevant. Management can screw up. You don’t want to over-lever to the point that these risks can swallow your company whole.
But then again, everyone in any job makes mistakes.