IPO drought drives private equity firms to load portfolio companies with debt

Private equity funds are increasingly pushing the companies they own to take on more debt so they can return cash to their investors, as the usual routes to cashing out of those investments stay shut, data from Moody's Ratings indicates.

Sales of company stakes through initial public offerings, and sales to other buyout funds or corporate buyers, have dried up in recent years. In their place, private equity sponsors have turned to dividend recapitalizations — adding debt to a portfolio company and paying the proceeds to the fund.

Moody's said "dividend recap" activity has surged since 2022 and expects it to remain high in Europe, the Middle East and Africa while company sales and IPOs stay subdued. The agency estimates private equity-owned companies in the EMEA region could take on a further 41 billion euros ($46 billion) in debt before reaching leverage levels that typically prompt a downgrade.

Limited to the strongest

Moody's analysis indicates the practice remains confined to the strongest-performing companies, which have the greatest capacity to absorb new debt — releveraging capacity that could support a further ramp-up in dividend recaps, the agency said. Services, consumer products and manufacturing are the most active sectors, and sponsors have stayed "disciplined" in choosing recap candidates, according to Moody's.

"The fundamental problem is that exits are few and far between – the European IPO markets have been muted, and the capital that would generally fund strategic purchases by large corporates has become a lot more expensive after the last rate hike cycle," Moody's analyst Mayank Mallik told CNBC. He said the agency is focused on how the broader private equity ecosystem affects corporate credit quality, calling it "one of the key transmission mechanisms currently."

Mallik noted most recaps involved companies that outperformed their original business plans, with the new debt generally returning leverage to its initial level without "materially" affecting exit opportunities. But he acknowledged a risk: companies preparing for IPOs like to show a track record of solid deleveraging before approaching the market, so issuers that have recently done a dividend recap may not be able to jump on a window that unexpectedly opens.

Distributions have fallen sharply. Moody's, citing PitchBook data, said private equity distributions dropped from more than 30% of starting net asset value in 2022 to about 12% today, and funds are now holding companies much longer than the typical period of around five to six years. If the exit backlog persists, sponsors may start looking at relatively weaker credits to monetize, Mallik said — a risk greater than a decade ago partly because documentation has become "quite permissive" for issuers raising additional debt.

Lenders still willing

Sunaina Sinha Haldea, global head of private capital advisory at Raymond James, said there is still "meaningful capacity" to fund recaps, helped by tight spreads and scarce new loan supply, though weaker earnings, wider spreads or investor withdrawals could tighten availability. Recaps are typically funded through the broadly syndicated loan market, high-yield corporate bonds or private credit borrowing.

Haldea said recaps provide liquidity without closing the valuation gap: "the asset remains in the fund and still needs an eventual buyer." More debt means less financial flexibility and, at the same enterprise value, less equity value left for shareholders when the business is eventually sold.

Source: CNBC.