Recapitalization Meaning
A recapitalization is a form of restructuring the ratio of various forms of capital generating modes such as debt, equity, and preference shares depending upon WACC and other requirements of the company such as the desired level of control and so on. In this process, the company issues one form of capital to buy back another form; for example, issuing debt to buy back existing shares to benefit from a favourable interest rate environment.
Types of Recapitalization
There are various types as below:
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- Leveraged Recapitalization: Issue of new debt to buy back existing shares of the company. Leads to an increase in the debt component and reduction in the equity component
- Leveraged Buyouts: Same as Leverage recapitalization but initiated by third parties to the company
- Equity Recapitalization: More equity or preference shares are issued to buy back the debt and reduce the debt component
- Nationalization: This mode is used by the government. Capital infusion in case of Public Sector Units or by paying off compensation for the equity of a private company
Example of Recapitalization
Around 2013, Dell went private. One of the main reasons for this was that Michael Dell wanted to grow faster and therefore needed greater control over strategic decisions without having to gain approval from several other stakeholders and the Board of Directors.
Further, going private would reduce the filling requirements of SEC, reducing the time and costs of paperwork. To undergo this change, Dell had to take a bank loan, and the costs saved from reduced paperwork and dividend payments would go to paying off the debt quickly in comparison to what it would have been able to thus it would be able to reduce the debt burden too. Also, it would bring greater flexibility to invest in R&D because it doesn’t need to payout enough dividends and can retain them; this may lead to faster growth.
However, in Dell’s history, this is not the only case of recapitalization; in 2018, i.e., 5 years later, Dell sought to go public again through a VMware stock swap deal, an alternative to the traditional IPO process. The motivation here was the growing ties with VMware and the expected growth in the market of the new product lines it had to offer.
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Benefits of Recapitalization
Benefit from Tax Shield
Interest on debt is tax-deductible, therefore increasing debt in the capital structure leads to an increase in the interest burden and, in turn, lower taxes. This could only be a motivation when:
- The company is sure of sufficient sales in the future to pay the interest because interest is an obligation and needs to be paid even without the company earning enough profits
- Interest cost is lower than the cost of equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more of an all-equity company
Reduce Interest Burden
Opposite to the previous motivation, when a company wants to reduce its interest burden, it goes for an Equity recapitalization because it may not want to part with some of its profits or incur losses in paying the interest, which is an obligation and independent of companies earning a profit. Even if the company earns a profit, it has the option of retaining it if it has growth opportunities to invest in. Therefore under such circumstances, it has the freedom that it doesn’t payout any dividendsPayout Any DividendsThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Incomeread more
Prevent Hostile Takeover Attempt
There are several takeover defense mechanisms which can lead to a recapitalization. The stock repurchaseStock RepurchaseShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more is when the target company buys back its shares from the market to reduce its availability for an acquiring company to buy such shares. In GreenmailGreenmailGreenmail is an intentional purchase of a substantial number of shares in an organization with an ultimate objective to jeopardize it with a hostile takeover, which usually results in forcing the owners to repurchase the shares at a premium.read more, the target company buys back the shared held by the acquiring company, and if it extinguishes these shares, then the capital structureThe Capital StructureCapital Structure is the composition of company’s sources of funds, which is a mix of owner’s capital (equity) and loan (debt) from outsiders and is used to finance its overall operations and investment activities.read more gets affected. In white squire defense, it buys back the shares of the minority and allots them to friendly partners.
Also, there may be a situation in which the target goes for a rights issue at a highly discounted price to increase the number of shares and make it difficult for the acquirer to acquire. In order to take any of these defenses, the target company may even issue debt or other forms of capital, leading to a recapitalization, and otherwise also these result in a change in the capital structure in their own way.
Boosting Public Sector Units
When the government takes the nationalization route, it is mainly to help certain sick PSUs to overcome their deteriorating balance sheetsBalance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more. At times when banks have very high levels of non-performing assetsNon-performing AssetsNon-Performing Assets (NPA) refers to the classification of loans and advances on a lender's records (usually banks) that have not received interest or principal payments and are considered "past due." In the majority of cases, debt has been classified as non-performing assets (NPAs) when loan payments have been outstanding for more than 90 days.read more, the government infuses capital so that these banks don’t go bankrupt. At other times, when the economy is slowing, the government uses the capital infusion to boost lending activity by the bank. All these lead to an increase in the government’s stake in the PSUs, which is a form of recapitalization.
Divestiture
The opposite of Nationalization is DivestitureDivestitureDivesting, also known as divestiture, refers to the sale or transfer of the significant assets, divisions, investment of the business due to some financial, political or social reasons such as a business can sell the department which is not a core part of the business and is not providing benefits to the company so that the business can focus on the units that can provide better earnings.read more, in which the government sells its stake to private parties with the motivation of reducing the government’s expenditure or losses or making such PSUs more efficient through privatization.
Control Desire
At times companies or management require greater control over the company, and for this reason, they may reduce the debt because debt-holders impose restrictive covenants on the risks that can be taken by the company or on the fresh capital issues.
Refinancing
At times when the interest rates become more favorable, companies may issue new debt just to recall old debt issued at a higher interest rate; this helps in reducing its WACC
Reducing Administrative Costs
There are several costs associated with being a publicly listed company related to disclosures and regulatory requirements. Such is not the case in private companies, and therefore at times, the companies may go private to reduce such costs when they become unbearable.
Recapitalization in Real Estate and Private equity
In real estate development, several parties come together, landowners, development partners, investors, and so on. However, each of these participants has different investment horizonsDifferent Investment HorizonsThe term "investment horizon" refers to the amount of time an investor is expected to hold an investment portfolio or a security before selling it. Depending on the need for funds and risk appetite, the investor may invest for a few days or hours to a few years or decades.read more and expectations regarding the market and returns, therefore at times, those having a longer time horizon and hopeful expectations recapitalize the stake of other participants for mutual benefit.
Recapitalization is used as an exit route in Private equity where the private owners sell a portion of their companies to take advantage of growth opportunities that require greater capital or reduce their stake or burden and yet retain some stake to benefit from future growth prospective.
Conclusion
Recapitalization is the process of altering the capital structure that would better suit the needs of the company, and the motivation behind it may vary from one company to another. It may lead to the desired result or may not and should be thought out decision.
It is a common process, and there are several real-life examples of capitalization as most companies require this tool at some point in their life cycle, and from time to time, the motivation to do so may be tied to a different objective.
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