Let’s start with how many private equity investment funds approach their market choices. Some will purchase a functioning company, pare costs to the bone and use the cash flow improvement in the company they purchased to pay off a new big fat juicy loan to get the buyout target ready to flip into the public or private marketplace at a substantial mark-up. That’s called a leveraged buyout. Debt is generally viewed as “cheaper than equity,” and with US interest rates still remarkably low, the urge of investors to take on that debt is an irresistible temptation.
But for many such private equity acquisition funds, there is another more ominous use for the debt, one that may erode the financial viability of the company they bought. In exchange for paying the old investors a purchase price based on a combination of an equity deposit plus that new debt – happy taken out investors – sometimes that debt is used to pay the new investors (the private equity firm) pre-negotiated minimum dividends, a risk reduction/exit strategy that can make these new investors whole without even having to put their acquired company back on the market to generate a rate of return. Those preset dividends can retire the private equity’s “at risk” equity, even generate a serious return on investment, and the debt belongs solely to the company they bought. Not the fund!!! Here’s a summary of such a “dividend recap” from Investopedia.com:
Dividend recapitalization is when a private equity firm issues new debt so as to raise money to pay a special dividend to the investors who helped fund the initial purchase of the portfolio company.
The dividend reduces the risk for the PE firm by providing early and immediate returns to shareholders but increases debt on the portfolio company's balance sheet.
A dividend recapitalization is often undertaken as a way to free up money for the PE firm to give back to its investors, without necessitating an IPO, which might be risky.
A dividend recapitalization is an infrequent occurrence, and different from a company declaring regular dividends, derived from earnings.
The investors get the benefit without their taking risk; the company gets the debt and the risks that go with that debt. Investopedia tells us what’s really going on: “The dividend recap has seen explosive growth, primarily as an avenue for private equity firms to recoup some or all of the money they used to purchase their stake in a business. The practice is generally not looked upon favorably by creditors or common shareholders as it reduces the credit quality of the company while benefiting only a select few.
“Prior to exiting a portfolio company, some private equity firms and activist investors opt to incur additional debt on the balance sheet of the company in order to deliver early payments to their limited partners and/or managers. This reduces the risk for the firms and their shareholders.
“This special dividend, in addition to not funding the portfolio company’s growth, weighs further on its balance sheet in the form of leverage. Significant new debt has the potential to become a drag in adverse market conditions, following the company’s exit.”
This may seem boring until you understand the role of these financial shenanigans in the most expensive healthcare system in the world: ours! We pay on average double the per capita medical expenditures as the rest of the developed world. That the needs of sick and disabled people are deprioritized to enable big fat private equity profits, that money is going simply to fund profits at the expense of investing improving healthcare, is a huge fact of life in American private equity trends.
Here is Bloomberg’s take (March 25th) on the extent of the practice in the world of healthcare, right smack in the middle of a major pandemic: “Healthcare companies are taking on more debt to pay dividends to their private equity owners, just a year after the start of a pandemic that plunged the industry into crisis… At least five U.S. healthcare firms have borrowed heavily in part to fund hundreds of millions of dollars of such payouts in the first quarter, according to a report by the nonprofit Private Equity Stakeholder Project.
“The practice, known as dividend recapitalization, is gaining steam as investors hunt for yield with interest rates near historic lows. Meanwhile, healthcare companies are on a stronger footing, with patient visits rebounding and the government unleashing economic stimulus… Healthcare firms have already borrowed about $3.7 billion in 2021, partly to fund payments to private equity owners, more than double the amount issued all of last year, according to data from S&P Global Market Intelligence.
“At the current pace, it would be the industry’s most active year for borrowing since 2015… ‘Investor demand for leveraged loans is outpacing supply so far this year, sending prices in the secondary market soaring,’ said Marina Lukatsky, a senior director at S&P… Dividend recapitalization is one reason wealthy investors are drawn to private equity, as they don’t have to wait years for a payout.
“Private equity’s main lobbying group, the American Investment Council [AIC], defended the practice, arguing that the loans are made to financially sound companies and help retirees because public pension plans are among the clients of private equity funds. Dividend recapitalizations accounted for just 6% of the total market for leveraged loans last year, the trade group said, citing S&P data.
“But critics including the Private Equity Stakeholder Project say the strategy destroys value… ‘By saddling companies with debt to extract cash for themselves, private equity firms put those companies at risk for restructuring, bankruptcy, or cost cutting to make up the interest payments and pay off that debt,’ said Eileen O’Grady, a coordinator at the nonprofit.” That a smattering of retirees make money, and many of those are rich retirees, the AIC does not address the massive upside paid out to the fund managers along the way. And the healthcare facilities that are the subject of the takeover are depleted, not improved, by the process.
Here's a specific example one healthcare facility where this process hurts the general public. “Mentor Network, which treats children and adults with intellectual disabilities… The Mentor Network… took on more debt and distributed $375 million to its owners — the second dividend since it was acquired two years ago by Centerbridge Partners and Vistria Group.
“While Moody’s warned of high debt, it said the company had ample cash to meet its obligations… In December, the Senate Finance Committee reported the findings of investigations into two Mentor Network affiliates, alleging poor patient care and a failure to report incidents of abuse and neglect… A spokesperson for the company declined to comment.” Bloomberg.
This is just one more reason why it’s time to stop an economic system that only benefits the richest few while saddling the rest of us with a thoroughly dysfunctional and exceptionally costly healthcare system. Making rich people richer by making sick people sicker seems an absurd result. And we are the only developed country on earth without universal healthcare. When you remember how big rich constituents fund political campaigns, the answer is obvious. When you hear folks speak of “creeping socialism” (dramatically misusing that word), take a look at the picture above and ask yourself who is making those statements… and why they want you to believe that clearly false statement.
I’m Peter Dekom, and a system that literally punishes most of us, some very seriously with life-threatening risks, just to make a very, very few people rich is not a democracy; it’s called a plutocracy.
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