What is leveraged recapitalization?

In a leveraged recapitalization, a business exchanges most of its equity for a bundle of debt securities, including senior bank debt and subordinated debt, altering its capitalization structure. Leveraged recap is another name for leveraged recapitalization. Put another way, the company will take out loans to settle outstanding shares and lower the proportion of equity in its capital structure. More stock may be granted to senior managers and staff to better align their interests with those of the bondholders and shareholders.

Since a capitalization structure that leverages debt is more advantageous to a firm during growth periods, a leveraged recapitalization is typically utilized to position the company for a period of expansion. When interest rates are low, leveraged recapitalizations are especially common since low-interest rates can make borrowing money more reasonable for businesses looking to pay off debt or equity.

Leveraged dividend recapitalizations are not the same as leveraged recapitalizations. The capital structure is unaltered in dividend recapitalizations because only a special dividend is distributed.

Knowing How to Recapitalize Leveraged

The structure of leveraged recapitalizations is comparable to that of leveraged buyouts (LBOs) insofar as it amplifies financial leverage. But they might continue to be traded publicly, unlike LBOs. Leveraged recapitalizations are less likely to affect shareholders than fresh stock issuances because the value of existing shares does not decrease with the issuance of new stock, but it does with borrowing money. Because of this, shareholders view leveraged recapitalizations more favorably.

Sometimes, private equity firms will use them as a means of refinancing or to exit a portion of their investment early. And unless they are dividend recapitalizations, they have effects comparable to leveraged buybacks. Utilizing debt may offer a tax shelter that justifies the additional interest costs. The Modigliani-Miller theorem demonstrates that debt offers tax advantages that are not possible with ownership. Additionally, leveraged recaps can all raise the price-to-book ratio, return on equity, and earnings per share (EPS). Repurchasing stock or paying off previous debts with borrowed funds also saves businesses the opportunity cost of using the generated profits for these purposes.

Leveraged recapitalizations, like LBOs, offer incentives to management to increase operational efficiency and discipline to meet more excellent principal and interest payments. To lower debt, they frequently come with a reorganization in which the business sells off unnecessary or no longer strategically appropriate assets. The risk is that an excessive amount of leverage can cause a business to lose its strategic focus and make it far more susceptible to unforeseen shocks or a downturn in the economy. If the current debt climate changes, rising interest rates may endanger the viability of corporations.

Leveraged Recapitalization’s Past

In the late 1980s, leveraged recapitalizations gained significant traction, mainly as a takeover defense in developed industries where significant continuing capital expenditures are unnecessary to maintain competitiveness. Raising a company’s leverage and the amount of debt on its balance sheet serves as a defensive mechanism against hostile takeovers by corporate spies.