Case 016Deal structuring and pricingCore

Explain a dividend recap with numbers: in year 3 a tableware company relevers from 2x to 5x EBITDA and pays the new debt out as a dividend. Compare MOIC and IRR with and without the recap, and say what it adds and what it risks.

TPGSan Francisco · 2015

The situation

A fund bought Madhavi Tableware, a maker of steel and ceramic kitchenware, with Rs 250 crore of equity. By year 3 EBITDA is Rs 90 crore and debt has fallen to 2x, Rs 180 crore. Lenders will now lend 5x, Rs 450 crore, at 10%, and the fund proposes to borrow the difference and pay it to itself as a dividend.

Without the recap, free cash flow repays Rs 30 crore of debt in each of years 4 and 5. Interest is tax-deductible at 25%. The fund exits at the end of year 5 at 9x EBITDA of Rs 110 crore.

Your task

Work the fund's MOIC and IRR with and without the recap, show the exit equity under each, and explain what a recap does to return, risk and the fund's reporting.

Quick check

The recap pays the fund Rs 270 crore in year 3. Does the total cash the fund receives over the deal go up or down?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Without the recap the fund makes 3.48x and 28.3%; with it, 3.32x and 32.9%. The recap pays Rs 270 crore in year 3, returning 1.08x of the original equity early, and exit equity falls from Rs 870 crore to Rs 560 crore because the debt is still there plus two years of extra interest. The IRR rises because cash comes sooner; the multiple falls slightly because the extra interest is real. The risk is 5x leverage into whatever the exit market does.

Step 1What actually happens in a recap?

A homeowner whose flat has risen in value and whose loan has shrunk can take a top-up loan against it and spend the cash; the flat is unchanged, the loan is bigger. A dividend recapA refinancing in which a portfolio company borrows more than it owes today and pays the extra to its shareholders as a dividend. The sponsor gets cash back before selling the company. is the same move by a sponsor: Madhavi borrows Rs 450 crore to replace Rs 180 crore, and the Rs 270 crore difference goes to the fund. The company's operations are untouched; its interest bill rises by 10% of Rs 270 crore, Rs 27 crore, or Rs 20.25 crore after tax.

Step 2What are the two sets of numbers?

Without the recap: debt falls from Rs 180 crore to Rs 120 crore by year 5; exit EV is Rs 990 crore; equity Rs 870 crore; 3.48x and 28.3% over five years. With the recap: debt starts year 4 at Rs 450 crore and paydown drops to Rs 9.75 crore a year, so debt is Rs 430.5 crore at exit and equity Rs 559.5 crore. Add the Rs 270 crore dividend and the fund receives Rs 830 crore in total, 3.32x, but with Rs 270 crore of it in year 3 the IRR is 32.9%.

The same company, two cash flow patterns for the fund, Rs croreWithout recap3.48xIRR 28.3%Yr 0Yr 1Yr 2Yr 3Yr 4Yr 5(250)+870With recap3.32xIRR 32.9%Yr 0Yr 1Yr 2Yr 3Yr 4Yr 5(250)+270+560Dividend from new debtTotal back870Total back270 + 560 = 830Less money back in total, but Rs 270 crore of it two years earlier: that is what lifts the IRR
Without the recap the fund waits five years for Rs 870 crore, 3.48x and 28.3%; with it the fund takes Rs 270 crore in year 3 and Rs 560 crore in year 5, less in total at 3.32x but 32.9% because the money comes sooner.
The relationship
MOICrecap=270+559.5250=3.32×0=−250+270(1+r)3+559.5(1+r)5⇒r=32.9%\text{MOIC}_{\text{recap}} = \frac{270 + 559.5}{250} = 3.32\times \qquad 0 = -250 + \frac{270}{(1+r)^3} + \frac{559.5}{(1+r)^5} \Rightarrow r = 32.9\%
270the dividend received in year 3
559.5exit equity in year 5 after the heavier debt
rthe IRR that sets the discounted flows to zero
What it says in wordsThe fund gets back 3.32 times its money rather than 3.48, but because Rs 270 crore arrives two years early the annual rate rises to 32.9%.
Step 3What does the recap risk?
Exit multipleNo recap: equityMOIC, IRRRecap: exit equityMOIC incl. dividend, IRR
5x4301.72x, 11.5%1201.56x, 13.3%
7x6502.60x, 21.1%3402.44x, 24.9%
9x8703.48x, 28.3%5603.32x, 32.9%
At a 5x exit the no-recap deal still returns 1.72x while the recapped company's exit equity shrinks to Rs 120 crore; the fund has banked Rs 270 crore, but the company carries 5x leverage into a weak market.

Three things, and an interviewer wants all three. Leverage: the company goes into years 4 and 5 at 5x with Rs 45 crore of interest against Rs 90 crore of EBITDA, so a bad year that was survivable at 2x is not at 5x. Reporting: DPI jumps to 1.08x in year 3, which helps the fund raise its next vehicle, and that incentive is why LPs ask who benefits. Governance: lenders, employees and a future buyer see a company that was stripped of its balance sheet capacity. The honest framing is that a recap converts future exit value into cash today at the cost of 10% interest and a thinner cushion; it is cheap when the business is stable and expensive when it is not.

Where candidates lose it

The usual loss is adding the Rs 270 crore dividend to the no-recap exit equity and reporting a higher multiple. The borrowed money is still owed at exit; total cash to the fund falls, and only the IRR rises.

The second miss is treating the recap as free. It adds Rs 27 crore of interest a year and takes the company from 2x to 5x, and the sensitivity at a 5x exit shows what that does to the equity.

What the interviewer asks next

  • The lenders add a covenant that leverage must fall to 4x by year 5. Can the company meet it from its own cash?
  • How does the recap change the fund's carried interest timing, and why do LPs care?
  • Would you still do the recap if the exit were two years away rather than one?

Asked at TPG, Generalist, San Francisco, 2015 (Wall Street Oasis): Paper LBO, walk me through an LBO, Exit strategy, good LBO candidates, why SF / Houston, why PE, explain a div recap

Company names and figures are illustrative.