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Earlier this summer, the private equity firm 3i paid itself over €1bn with money one of its companies had borrowed, helping bring the volume of these so-called “dividend recapitalisation” to a new record.

On one hand, this demonstrates how much value private equity firms can create for their investors. 3i paid just €130mn for a controlling stake in the Dutch retailer Action back in 2011, and since then it has extracted about €4.5bn from the company through eight dividend recaps.

The company has been able to keep borrowing to chuck money back to its owners thanks to a huge increase in its earnings over the past decade (Bryce wrote a great post on how big a deal Action is for 3i here). Here at FT Alphaville we’ve been somewhat sceptical of the private equity investment case, but this is a clear winner.

On the other hand, companies borrowing more and more money purely to pass it on to private equity owners isn’t really a good look, and can cause problems further down the line.

This is particularly pertinent given that MainFT is reporting that private equity firms are pushing for changes to loan docs that would allow them to pay themselves even bigger dividends. (remember when private equity barons insisted back in 2023 that they would “go back to investing in the old-fashioned way” and rely more on operational nous than leverage? Good times).

All this is why FT Alphaville was so intrigued to spot this paper by Abhishek Bhardwaj, Abhinav Gupta and Sabrina Howell in our weekly round-up of research published by NBER, which put some number on the general vibes around dividend recaps.

It argues that the strategy:

. . . lead to misaligned incentives and moral hazard problems for GPs, causing them to pursue activities that diverge from the interests of fund investors, company employees, and pre-existing creditors.

Here’s how the study worked: Across the sample of about 47,000 US leveraged buyouts by 1,200 private equity firms between 1995 and 2020, the researchers found almost 1,600 dividend recaps. They then paired this with data on loans, fund returns, payrolls and bankruptcies.

Bhardwaj, Gupta and Howell found that dividend recaps mostly happen at larger, healthier companies. This makes sense, as it’s a lot easier to get creditors to feel comfortable with this kind of financial milking when they can see solid cash flows coming in.

Once you adjust for that, dividend recaps massively increase the danger of bankruptcies:

. . . The causal analysis paints a picture in which new debt induced by cheap credit increases firm risk, consistent with theories predicting agency problems of debt. We focus first on the firm. We show that dividend recaps increase the chance of bankruptcy, for example by 31pp in the following six years. This is large relative to the sample mean of 1.3%.

On the other hand, if a company survives, dividend recaps also appear to increase the chances “exceptionally good outcomes” — ie strong revenue growth and IPOs. That might be because dividend recaps make companies more of a binary bet, and encourage it to go for broke. From the paper:

Having realized good returns from the targeted portfolio company, the GP may encourage its managers to take more risk because the investment’s payoff has become more call option-like.

However, turning to returns, the researchers found that dividend recaps were positive for the returns of individual deals, but seemed to be negative on a fund’s overall returns. Here’s their explanation for this weird phenomenon:

At the fund level, we show that dividend recaps decrease the fund’s cash-on-cash multiple and public market equivalent (PME) return measures. There is no effect on IRR, consistent with bringing cash flows forward in the fund’s life. What might explain a positive effect on deal returns yet a negative effect on fund returns? We show that dividend recaps dramatically increase short-term distributions paid out to the fund, which could incentivize the GP to raise a new fund on the basis of good interim returns, consistent with Gompers (1996) and Barber and Yasuda (2017). Indeed, dividend recaps sharply increase the chance of launching a new fund.

These results suggest that dividend recaps are used to benefit GPs by enabling early distributions and new fundraising. In turn, they may focus their effort more on the new funds. Consistent with this, we observe that dividend recaps cause lower returns for subsequent LBOs within the fund and reduce number of new LBOs pursued, relative to funds of the same vintage.

So what about the impact of people that work at companies that have done a dividend recap?

You’ll probably be entirely unsurprised to learn that they are “largely negative”, even for companies that survive and thrive despite leveraging up to make payments to the private equity owners.

We find a large negative effect on wage growth of-53%, relative to a mean of-4%. This is driven by declining payroll, especially at the left tail (i.e., the worst performers among survivors). There is a negative albeit insignificant effect on employment growth, driven by greater chances of being in the tails of the distribution, with a significantly lower chance of modest positive employment growth.

Overall, the results suggest that by making firms riskier, dividend recaps raise the specter of bad outcomes for workers — exit, bankruptcy, and significant wage declines — but also increase the chance that the firm experiences a good outcome for owners (IPO, large revenue increases).

Still, at a time when private equity firms are under immense pressure to return money to investors — they’ve now raised more money than they’ve handed back for six straight years — and rates are now falling, FTAV suspects that dividend recaps are going to boom even harder in the coming years.

As the paper concludes:

. . . Our analysis implies that rising CLO demand will increase opportunistic dividend recaps, with negative implications for portfolio company and stakeholders including employees, pre-existing creditors, and fund investors.

Good morning and welcome to your Morning Briefing for Friday 20 September 2024. To get this in your inbox every morning click here.

IHT receipts continue to rise as speculation mounts ahead of Budget

The Treasury collected £3.5bn in inheritance tax receipts between April to August, latest figures from HMRC published this morning (20 September).

This is £300m higher than the same period last year.

Another record-breaking year for IHT receipts is being predicted and experts believe this upward trajectory will continue year on year and hit £9.7bn in 2028/29.

However, there are rumours that IHT will be increased next month when the new Labour government unveils its first Budget.

How to enter the international advice market

The ebb and flow of the global economy means that, as some people migrate to the UK, others leave it, creating opportunities for international financial advice.

The new Labour government has confirmed that the current tax regime for non-UK domiciled individuals will be replaced with a residence-based test from 6 April 2025, so international advice firms can expect more enquiries.

If UK advice firms want to develop a global presence, how should they go about it?

Quote Of The Day

The complexity of the current system often leads to confusion and inequities.

-Shaun Moore, tax and financial planning expert at Quilter, comments on latest IHT receipts which hit £3.5bn as rumours of tax changes build ahead of October budget.

In Other News

FE Fundinfo has announced the release of its enhanced Factsheet Production solution. This automated system will streamline factsheet production and distribution to FE fundinfo’s network within a single workflow. It offers a user-friendly interface with a progress dashboard, supports approve/reject workflows, provides a comprehensive audit trail, and includes a 10-year archive.

With the capacity to produce up to 150,000 documents per hour and support for translations into 30 languages, it is scalable and compliant, enabling asset managers to efficiently manage their global operations.

Integrated into FE fundinfo’s comprehensive end-to-end platform, the Factsheet Production solution provides asset managers with a single, trusted source of data. This golden source enables connections with distribution networks, regulators and investors, ensuring the automatic dissemination of factsheets.

“Asset managers today are facing unprecedented challenges, from regulatory pressures to the need for process optimisation in a rapidly changing market,” said Joerg Grossmann, chief product officer at FE fundinfo. “Our enhanced Factsheet Production solution is designed to help meet these head-on.”

SimplyBiz has announced over 1,000 Defaqto Engage licences have been adopted by its member firms since an enhanced version of the financial planning system was added to its core membership package five months ago.

Forming part of SimplyBiz’s suite of market-leading technology solutions and designed to help advisers manage regulatory risk, increase efficiencies, and deliver better services to clients, Engage brings together a range of previously standalone modules, from risk profiling and cashflow modelling to pension, product, and platform switching, into a single comprehensive package.

Used by around 30% of UK advisers, Engage is powered by Defaqto’s data which covers more than 21,000 funds, platforms, DFM MPS, and products, with recommendations of £43bn going through the system annually.

Legal & General Group Protection has partnered with Vocational Rehabilitation specialist Ergocom to provide employees with the support they need following a Group Income Protection (GIP) claim.

It’s designed to help both the employer, and their employee understand what job roles the individual can do, and what is needed for them to continue working in a new role.

This service will be made available following a GIP claim, where the employee is ready to work, but due to personal circumstances, they can no longer fulfil their previous role and, as a result, will be supported to seek alternative options. This new service has the potential to include everything from individual assessment and detailed reporting, to coaching which helps the employee develop additional skills and confidence.

Ergocom’s Vocational Redirection Assessment will examine the employee’s vocational strengths, needs and career potential, considering any barriers or functional limitations to identify suitable, alternative roles.

Government borrowing in August highest since Covid (BBC)

Ministers and union leaders to hold crunch talks over workers’ rights plans (The Guardian)

Nike chief executive John Donahoe to step down (Financial Times)

Did You See?

The Financial Conduct Authority has launched an investigation into pure protection and it’s safe to say it’s pretty damning, writes Andrew Gething, managing director at MorganAsh.

Not only is the regulator ordering insurers and intermediaries to remove products that do not offer fair value, it’s weighing up action to address these issues, as well as not demonstrating good customer outcomes.

It’s a stark reminder of the regulator’s intent to enforce the Consumer Duty, which is now in full force. In fact, the FCA highlighted its commitment to engage with both GI and protection, as well as relevant trade bodies, to ensure its expectations are recognised and acted upon urgently.

A key shortcoming identified by the regulator was an inability by firms to demonstrate how they assess whether a product delivers fair value to all customers, including vulnerable or outlier groups.

Read the full article here.

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It’s Friday, so here are some charts. Identify what they show and email your answers to alphaville@ft.com with “Quiz” in the subject line by midday Monday, and you could win a t-shirt.

It is our ancient custom to name those who get the answers right, so let us know if you don’t want your name used.

With no further ado…

Good luck.

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European Commission president Ursula von der Leyen travelled to Kyiv on Friday to announce a multibillion EU loan for Ukraine as part of a G7 plan to raise $50bn on the back of future profits from frozen Russian state assets.

On her eighth visit to Ukraine, von der Leyen wrote on X upon arrival that she would meet leaders in Kyiv to discuss a range of issues from “winter preparedness to defence, to [EU] accession and progress on the G7 loans”.

The loan announcement comes at a time of additional and urgent need of Ukraine aid due to Russia’s repeated attacks on its energy infrastructure, and after months of negotiations with G7 partners about their share and structure of the loan.

“These assets should be used to protect lives in Ukraine against Russian aggression,” President Volodymyr Zelenskyy said on Thursday evening.

“There is a clear decision regarding $50bn for Ukraine from Russian assets, and a mechanism for its implementation is needed to ensure that this support for Ukraine is felt in the near future,” he added.

G7 leaders agreed in June to make $50bn available in loans to Ukraine and divide that according to their relative economic weight, which would have resulted in the EU and US covering $20bn each, with Canada, Japan and the UK making up the rest.

But the US conditioned its participation on legal reassurances that the assets would stay frozen for longer. The EU, where nearly €200bn of Russian state assets are immobilised, has however been unable to guarantee that, due to Hungary’s opposition to extending the sanctions regime against Russia.

To make up for American no-show and bypass Budapest’s veto, the commission sought to increase its share of the loan to up to €40bn, guaranteed against the bloc’s common budget. But EU capitals baulked at the figure, pressuring Brussels to get the UK, Canada and Japan to increase their share.

A majority of EU countries and the European parliament need to approve the EU loan before year’s end.

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Well that makes my katzenjammer even worse. On top of a cold, as well as a hangover from trying to match dad — who just landed from Australia — on the shiraz front, my portfolio now lags behind the 60-80 per cent equity index in the table below for the first time this year.

As wake-up calls go, less a splash of water on the face and more a slap. I had long ceased hoping to outdrink the S&P 500 in 2024 — the AI boom and strong pound ensured that. But beating a benchmark hand-chosen by me?

Two months ago my portfolio was 250 basis points ahead of the Morningstar index in the year to date. How did I stuff up? Well, for starters, it has slightly more equities than me and they continue to rally the world over.

But my 74 per cent weighting is my decision, so no excuse. Another reason I trail the benchmark is because well over half of its bond exposure is sterling-denominated. Only Treasuries comprise my fixed income fund.

While many saw entrenched US inflation, I was correct in thinking that short-end interest rates would eventually head south again. The Federal Reserve’s half-point cut in policy rates on Wednesday sits nicely with this view.

That said, I didn’t think through the purchase of a non-hedged exchange traded fund. If I were correct on lower short-term rates, the dollar would probably decline versus the pound. Thus my Treasury fund is only flat since January. And it’s in the red this week.

Two months ago my portfolio was 250 basis points ahead of the Morningstar index in the year to date. How did I stuff up?

Annoying or what? Especially as the returns this year from my UK and Asian equity funds are both in double digits. But a valuable lesson learnt. It is fine making currency bets but not if they are inconsistent with your core thesis.  

Finally, Japanese stocks are still reeling from the hiki-taoshi they received in early August. Like pulling an opponent to the floor in sumo, the Nikkei 225 index collapsed by a fifth under the weight of a strong yen and investor nerves.

Onward and upward, though! There is still more than a quarter to go until the year is done. So how do I rate the structure of my self-managed portfolio today — the existing positions as well as the gaps? On what am I focused?

It seems to me I have to answer three very important questions if I want to boost significantly the value of my pension pot before Christmas, let alone achieve an annual return commensurate with the goal of doubling my assets in the next eight years.

The first is: how much risk I am willing to take? Losing half of my chips on the first spin of a roulette wheel and then choosing correctly the next two times also doubles my money — green pocket excluded. But the trade-off between returns and volatility is terrifying (a Sharpe ratio of 0.5, in this case).

So yeah, I could own just one stock and be lucky. At the other extreme, an academic paper over the summer by Ronald Doeswijk and Laurens Swinkels — beautifully summarised by my colleagues on Alphaville — proves the value of extreme diversification.

Hypothetically a fund owning everything would not only have produced an excess return over cash of 0.3 per cent per month between 1970 and 2022, but a Sharpe ratio above each of the component assets too. A genuine free lunch.

It wouldn’t have my portfolio in seven figures by 60, however. So while I don’t want to put the lot on black, I know I need to take more risk in order to retire early. And that probably means the US government bond ETF has to go.

As an aside I may return to before November 5, if you think a razor-close US election may result in chaos or worse — and some experts fear as much — adding risk makes no sense at all. Indeed, 100 per cash is the way to go.

Either way, America is the second question I need a clever answer to. In summary, one of my first columns urged readers to always own US equities, but in a rush of blood last year I sold the lot when valuations got ridiculous. It was a mistake — as it usually is.

What do I do now? As my children know, I’m fine with losing face and would buy in again. Yet for me, the S&P 500’s forward price-to-earnings ratio of 24 times is still bonkers. Nvidia’s market cap is above 50 times its book value. I’ve seen this tech movie before.

US medium-cap stocks offer a better storyline, perhaps, being 25 per cent cheaper relative to forward earnings than the S&P 500. Margins have held up OK too, as me old mucker Robert Armstrong pointed out this week.

But I worry about the index’s preponderance of banks. Sure, their real estate loans are less likely to implode as rates fall, as Robert argues. But if the US economy stays robust, lenders prefer higher rates as they mean wider spreads.

Money Clinic podcast

Can Stuart Kirk double his money in eight years? Claer Barrett talks to Stuart Kirk at the FT Weekend Festival

Still, I noticed recently that large US companies are investing more again, with the S&P 500’s capex-to-sales ratio back to pre-Covid levels. AI spending within the Big Tech sector has a lot to do with it, but this money will eventually flow to mid-caps too.

My third mega-question is China, the topic of a whole column soon. The word “Japanification” is now being whispered among professional investors. Will China repeat Japan’s lost decades, with low growth, a falling population, high debts and real estate woes?

I need three mega-answers soon. Should have taken a summer break after all.

The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__

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Private equity firms are aggressively pushing to include language in loan documents that could give them room to pay themselves larger dividends from the companies they have bought, drawing a sharp rebuke from lenders.

In the past, loan documents usually capped exactly how much money a private equity firm could extract from one of its portfolio companies. Over time, those fixed amounts became malleable and were based on a percentage of a company’s earnings.

But in recent weeks, private equity firms have been attempting to take things one step further with the so-called high-water ebitda provision, which allows a company to use the highest earnings it generates over any 12-month period for critical tests that govern how much debt the company can borrow or the size of dividends it can pay to its owner, even if the business’s earnings have slid since reaching that high point.

KKR, Brookfield, Clayton, Dubilier & Rice and BDT & MSD Partners have all attempted to work the clause into loan documents, according to people briefed on the matter. All four firms declined to comment.

The terms have received intense pushback from would-be lenders, and in almost every case the language has ultimately been stripped out of the loan documents. But the fact that private equity-backed companies continue to push for the inclusion of the language has lenders on edge, with some fearful rival creditors will buckle and accept the provision.

According to lenders who saw drafts of the loan agreements, the terms were included in provisional loan documents backing KKR’s buyouts of asset manager Janney Montgomery Scott, valued at roughly $3bn in the deal, and $4.8bn purchase of education technology company Instructure, as well as Brookfield’s $1.7bn acquisition of a unit of nVent Electric. The clause was also put in provisional documents for refinancings by Wesco, which is owned by BDT & MSD Partners, and CD&R’s Focus Financial.

“It’s a really aggressive term,” one creditor said. “It’s a tough time to say, ‘I’m going to push the envelope further.’”

In one deal, RBC, which was lead underwriter on the $900mn term loan Brookfield was raising for its investment in nVent, told an investor that the bank had strong demand and if the language was an issue they should “vote with [their] feet”.

When enough investors passed, the high-water language got pulled from the loan document.

RBC did not immediately respond to a request for comment.

The fact the language is being tested is one sign of a potential imbalance in the loan market, a critical source of funding for private equity buyouts. With buyout volumes still down from the 2021 peak, investors have had fewer new deals to spread their funds across, leading to heightened competition around some loans.

“When you’re in a strong market, it’s usually harder to push back against” these terms, one banker involved in the Instructure financing said. But, he added, “they’re not surviving.”

The language has made it into at least one deal, a $2.1bn term loan for a commercial laundry operation known as Alliance Laundry, according to two people briefed on the matter. The company planned to use the proceeds to refinance debt and pay a $890mn dividend to its owner, BDT & MSD, according to S&P Global and Moody’s.

The provision reads that “the borrower may deem Ebitda to be the highest amount of Ebitda achieved for any test period after the closing date . . . regardless of any subsequent decrease in Ebitda after the date of such highest amount”, text seen by the Financial Times showed.

“If you didn’t ask for those terms in a negotiation you didn’t do your job,” one private equity executive said. “You always want to give maximum flexibility to your businesses.”

The high-water concept is not foreign to creditors; it is far more prevalent in European leveraged finance markets. And some bankers and lawyers argue the idea is rooted in common sense.

In certain loans, the amount of future debt a company can borrow or the sums it can dividend out to its owner is set as a percentage of earnings. Companies like that flexibility, because if they are growing they do not have to keep amending their loan documents if they would like to borrow or distribute more cash. Investors said savvy lawyers decided to push that concept one step further.

The high-water provision creates a threat for would-be investors, particularly if a business begins to slow before a loan matures.

“Over time the protections that were built into credit agreements by commercial banks have deteriorated,” said Tom Shandell, Investcorp Credit Management’s head of US CLOs and broadly syndicated loans. “Private equity [firms], which can afford the best and brightest attorneys, have little by little put terms into credit agreements that weaken the protections.”