The Cocaine of Private Equity

This morning’s Financial Times business headline read, “Leveraged recaps ‘could increase defaults.'” As most of us know, cocaine can be very hazardous to your health. Those of you who don’t this are not likely to be reading this, so – as I was saying…Leveraged recaps are “a refinancing method that allows private equity groups to suck out large dividend payments by loading their portfolio companies with additional debt.” Barron’s dictionary of finance and investment terms dictionary goes further. Defeasance (another name for recaps) is “a technique whereby a corporation discharges old, low-rate debt without repaying it prior to maturity. The corporation uses newly purchased securities with a lower face value but paying higher interest or having a higher market value. The objective is a cleaner (more debt free) balance sheet and increased earnings in the amount by which the face amount of the old debt exceeds the cost of the new securities. The use of defeasance in modern corporate finance began in 1982 when Exxon bought and put in an irrevocable trust $312 million of US government securities yielding 14% to provide for the repayment of principal and interest on $515 million of old debt paying 5.8% to 6.7% and maturing in 2009. Exxon removed the defeased debt from its balance sheet and added $132 million – the after-tax difference between $515 million and $312 million – to its earnings that quarter.”Default rates are estimated at around 6 percent on these types of actions. The traditional leveraged loan market has a default rate of about 1.53 percent.

What does this all mean? Take the case of Hertz. The Financial Times reports that Standard & Poor’s believes the car group was sold by Ford to a private equity group (CDR) for $15 billion. It seems the new owners paid themselves a dividend of $1 billion about six months after the sale. FT reports that since the beginning of the year, there have been 63 LR’s valued at more than $25 billion. With a default rate of about 6 percent, this could amount to more than chump change. “Large leveraged recap deals in the US include Metro-Goldwyn-Mayer, Regal Cinemas and Burger King…”