Private Equity Firms Turn to Debt Markets Amid IPO Drought

Private equity funds are increasingly pushing portfolio companies to borrow more to return cash to investors, data suggests. These transactions, known as dividend recapitalizations, have surged since 2022. Traditional ways of monetizing investments, including IPOs and sales to other private equity funds or buyers, have dried up in recent years. Additional debt risks weakening portfolio companies' ability to invest or withstand future trading downturns.

Moody's Ratings expects dividend recapitalizations to remain high in Europe, the Middle East and Africa while company sales and IPOs remain subdued. Moody's estimates that private equity-owned companies in the region could borrow another 41 billion euros ($46 billion) before reaching leverage levels that typically prompt a downgrade. Moody's analysis indicates that dividend recapitalizations remain limited to the strongest-performing companies with the greatest capacity for additional debt. Moody's analysis indicates that this borrowing capacity could support a further increase in dividend recapitalizations.

Dividend recapitalizations do not resolve the exit backlog, which is forcing funds to hold companies much longer than the typical five to six years. Moody's analyst Mayank Mallik said European IPO markets have been muted. Mallik said capital for strategic acquisitions by large companies has become much more expensive after the last interest-rate increase cycle. Mallik described dividend recapitalizations as a key mechanism through which the private equity ecosystem currently affects corporate credit quality.

Moody's said private equity sponsors have remained disciplined in selecting dividend recapitalization candidates. Moody's identified services, consumer products and manufacturing as the most active sectors. Mallik said most dividend recapitalizations have involved companies that outperformed their original business plans. Mallik said the additional debt generally restores initial leverage levels without materially affecting exit opportunities. However, Mallik said companies preparing for IPOs like to demonstrate a couple of years of solid debt reduction before approaching the market. Mallik warned that companies completing dividend recapitalizations could miss an unexpected IPO opportunity. Mallik said a company undertaking a dividend recapitalization is likely assuming the IPO market will remain closed in the short term.

Moody's, citing PitchBook data, said private equity distributions fell from more than 30% of starting net asset value in 2022 to about 12% today. Mallik warned that a prolonged exit backlog could encourage sponsors to monetize relatively weaker companies, potentially worsening credit quality across portfolios. Mallik said those risks are greater than a decade ago, partly because documentation has become quite permissive for issuers seeking additional debt.

Portfolio companies typically fund dividend recapitalizations through broadly syndicated loans, with several investment banks lending together to spread risk. Companies can alternatively raise funding through high-yield corporate bonds or private credit. Sunaina Sinha Haldea, global head of private capital advisory at Raymond James, said meaningful capacity to fund dividend recapitalizations remains. Haldea said tight spreads and scarce new loan supply support lender appetite. Haldea warned that weaker earnings, wider spreads or investor withdrawals could reduce financing availability. Haldea said a recovery in acquisition financing would give lenders more alternatives to funding shareholder payouts.

Haldea said dividend recapitalizations provide liquidity and ease pressure to sell without resolving the valuation gap. Haldea said investors receive some cash, but the asset remains in the fund and still needs an eventual buyer. Haldea said a dividend recapitalization need not disrupt an exit if earnings growth has created genuine borrowing capacity. However, Haldea cautioned against borrowing based on hoped-for growth. Haldea said more debt means less financial flexibility and, at the same enterprise value, less equity value for shareholders when the business is eventually sold.