Dividend Recaps: How Private Equity Is Sucking the Life Out of Good Companies


"Neither a borrower nor a lender be; For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry."

-- Shakespeare, Hamlet, Act 1, Scene 3

Shakespeare was right, of course. And it's the "borrowing" that's particularly pernicious -- especially when it comes to the kind of borrowing used by high-powered investors to take companies private. By buying public companies, loading them up with debt, and spinning them back out to unsuspecting investors in the form of overhyped IPOs, America's private-equity firms are ruining some of your favorite brands.

A recent article in The Wall Street Journal tells the tale. In a "going private" transaction last year, private-equity firms Leonard Green and CVC Capital bought BJ's Wholesale Club for $2.8 billion. BJ's was a struggling rival to dominant warehouse chain Costco (COST) and Walmart's (WMT) Sam's Club. It's understandable that a bunch of high-powered investors, seeing a chance to make BJ's even better, wanted to buy it and do some tinkering behind the scenes, free from the constraints of having to answer to public shareholders.

The problem was, "improving" BJ's wasn't what the buyers had in mind. Rather, they were plotting a "dividend recap."

After taking BJ's private, LG and CVC ordered the company to pay them a $643 million dividend -- equal to the entire cash outlay they'd made in the purchase. (They'd borrowed the balance). Of course, BJ's didn't actually have $643 million, so to pay their dividend, the new owners had BJ's take out a loan.

If all goes according to plan, they'll eventually re-IPO BJ's back to the public in a few years -- at which point, new individual investors will get stuck with its debt.

An Oft-Told Tale

If that's how things go with BJ's, it won't be the first time. "Going-privates" that turn into "dividend recaps" and ultimately evolve into "re-IPOs" are surprisingly common.

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Take Restoration Hardware. When private equity firm Catterton Partners bought Restoration for $267 million back in 2008, the company owed $103 million in long-term debt. Four years later, Restoration returned to market in an IPO valuing it at $1.2 billion. But rather than being less leveraged and better able to compete, the "new and improved" Restoration Hardware emerged with $144 million in long-term debt -- more than when it went private!

Or consider the case of Bankrate (RATE), the go-to website for homeowners seeking a quick quote before refinancing a mortgage. When Apax Partners purchased Bankrate in 2009, the company was a model for how to efficiently run an Internet business. Debt-free, cash-rich, and profitable, Bankrate was bought for $570 million.

Within a year, though, Bankrate was in trouble. Soon after taking the company private, Apax saddled it with more than $220 million in debt. This helped push Bankrate from the black into the red, where it remained up until it re-IPO'ed last summer.

Bankrate's better now, earning profits and paying down its debt. But one suspects this only makes it a tastier target for a new buyout. After all, after taking Bankrate, breaking it, then selling it back to us, Apax managed to get a $1.5 billion market cap on the Bankrate re-IPO.

Pet Project

Probably the most famous "full circle" transition is Petco, the pet supplies superstore. In 2000, Leonard Green (yes, them again) teamed up with Texas Pacific Group to take Petco private for approximately $600 million. Two years later, the company IPO'ed at twice its buyout price -- $1.2 billion -- producing a windfall profit for its private equity owners.

And yet, when Petco came public again, it was one sick puppy -- losing money, and bearing close to $400 million debt, versus less than $90 million when it went private.

After several years of profitable operations post-IPO, during which time the company steadily improved its operations, earned profits, and paid down its debt, Petco was taken private once more, in 2006, by the same private equity shops that had bought it in 2000. (Investors actually made out OK on this deal. Buying at the bottom of the Internet Bubble-burst, and riding the rebound, they netted an 80 percent gain by the time Petco was re-acquired.)

What It Means to You

So, it worked out well for Petco investors. But what do all these corporate comings (public) and goings (private) mean for the rest of us?

By buying companies, sucking out their cash in sweetheart dividend deals, and loading them with debt, private equity firms are hurting some of our favorite brands. Many of these companies are forced to cut costs in order to repay their creditors. To do this, they may need to lay off employees or close underperforming stores, degrading customer service. Money they might have been invested in store improvements, or lowering prices, may instead be needed to pay down debts racked up during years of private ownership.

When a company announces it's getting bought out, newspapers love to write about the price being paid. The rest of us, well, we should be more concerned about the costs.

Motley Fool contributor Rich Smith does not own shares of any company named above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale.
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