Earlier this year Ancestry.com refinanced their debt and paid a $910 million dividend to its private equity owners. A dividend recap happens when a company incurs a new debt in order to pay a special dividend to private investors or shareholders. This usually involves a company owned by a private equity firm, which can authorize a dividend recapitalization as an alternative to the company declaring regular dividends, based on earnings. Dividend recaps allow private equity sponsors to receive a return on their original investment without having to sell the company or conduct an IPO. The portfolio company, however, has to service the debt with interest/principal payments and are subject to various covenants (cash flow, EBITDA, etc.) that can impede their operations and ability to operate. In 2019 private equity dividend recaps are rising again.
In 2006 I was a senior executive for a private equity backed technology firm. Like many companies in the post DotCom era it had struggled and been purchased by a well known private equity firm in 2002. The company had been unprofitable and required significant operational restructuring. In 2006 the company conducted a dividend recapitalization to refinance its existing debt and pay a $100 million dividend to its investors. That represented over a 2.8x return on their initial investment. I received a significant bonus from the refinancing. The new debt was ‘covenant-lite’ and rated as junk debt. The covenants were significant, but not too onerous. The company was eventually acquired in 2010.
Dividend recaps reached a peak in 2007 and then virtually collapsed with the financial crisis of 2008. They recovered to reach record levels in 2010.
Historically private equity investment in software technology companies had been driven primarily by financial engineering. Tactics like significant headcount reductions were common. A dividend recap is a classic example of financial engineering. Starting in 2014 a new trend in tech private equity emerged – Growth Equity investing:
Growth equity focuses on making fundamental improvements and investments in growth instead of cost reduction and financial engineering. An excellent example of this was Vista Equity’s investment in marketing automation provider Marketo. As noted in Marketo: A Growth PE Success Story
Marketo was founded in 2006 by a group of ex-Epiphany executives. It went public in 2013 and was struggling in 2016 when it’s revenue growth rate declined by 50%. Marketo was executing a growth at any cost strategy and had posted a -$50 million in EBITDA. They were acquired by Vista Equity for $1.79B – a 62% premium over its prior closing price. Adobe acquired Marketo from Vista in August 2018 for $4.75B – a hefty return and Vista’s single largest exit to date.
Vista brought in a new CEO for Marketo – SAP executive Steve Lucas, who had significant experience in growing enterprise software businesses. When Vista buys a company, all employees and recruits are required to take a personality-and-aptitude test, like one first developed by IBM. The hour-long test assesses technical and social skills, and attempts to gauge analytical and leadership potential. Vista also leveraged their Vista Standard Operating Procedures aka their secret sauce. It is basically a guidebook for growing software companies. Vista also leveraged their bootcamp training programs. Boot camps train employees, not just for two weeks but for six to nine months. In the past three years, Vista has put 12,000 new hires through these boot camps. They start by giving employees the big picture: how the Vista company makes money, and the way customers use its products. The focus later shifts to specific corporate roles.Marketo: A Growth PE Success Story
Growth equity has become the new normal for private equity in the software world.
Dividend recaps on are the rise in 2019:
While they are not at the levels of 2010, continuing low interest rates and market tolerance for covenant-lite debt offerings are encouraging more private equity sponsors to consider dividend recaps as a way of generating returns sooner versus later. Even growth equity powerhouse Vista Equity recently sponsored the $175 million recapitalization of its portfolio company Meltwater.
Product managers are generally far removed from dividend recaps. On one hand, product managers should be reassured if their firm conducts a dividend recap. It means that debt investors have confidence in their company’s ability to execute despite the additional principal and interest payments a recap involves. On the other hand, even covenant-lite debt recaps will reduce free cash flow available for investment in new products and initiatives. Money that could be used to fund new development will go instead to service the debt. EBITDA coverage requirements (aka EBITDA-To-Interest Coverage Ratio) could result in the company focusing on growing and maintaining EBITDA levels instead of investing in new solutions. Product managers should be cognizant of these requirements and be prepared to rigorously defend their investment recommendations.
Also published on Medium.