The Decline in Carried Interest and the Growth of Dividend Recapitalizations in Enterprise Software Companies

In the ever-evolving world of private equity (PE), the decline in carried interest has driven a significant shift in strategies, with dividend recapitalizations emerging as a prominent trend. This article explores the reasons behind this shift, its impact on the enterprise software sector, and insights from industry experts.

The Decline of Carried Interest

Carried interest, a performance fee paid to private equity managers, has traditionally been a significant source of income for PE professionals. However, several factors have contributed to its decline:

1. Increased Competition: The private equity landscape has become highly competitive, making it harder to achieve the favorable entry multiples, profit stream changes, and deleveraging that drive carried interest.
2. Taxation Changes: In the UK, carried interest is now taxed as income rather than capital gains, reducing the net earnings for PE professionals.
3. Low Exit Activity: With private equity exits at a five-year low, achieving carried interest has become increasingly challenging. For instance, Blackstone’s private equity division reported negative realized performance compensation in the second quarter of 2024.

Rupert Bell of Private Equity Recruitment (PER) highlights the shift in focus: “Improving the operating model is now paramount”. As carried interest dwindles, PE professionals are increasingly seeking equity in the general partnership, which remains taxed as capital gains and can be highly lucrative.

The Rise of Dividend Recapitalizations

As carried interest becomes less attractive, private equity firms are turning to dividend recapitalizations to generate returns. In these transactions, a company takes on additional debt to pay dividends to its shareholders, allowing PE firms to extract liquidity without selling their investments.

Factors Driving the Growth of Dividend Recaps

1. Market Conditions: The lack of viable exit options, such as sales or IPOs, has led PE firms to leverage dividend recaps to provide returns to investors.
2. Investor Pressure: Limited partners (LPs) in private equity funds rely on annual distributions. Dividend recaps help meet these liquidity needs while allowing PE firms to hold onto their assets longer, potentially achieving better returns upon exit.
3. Attractive Debt Terms: Despite high interest rates, private debt funds have become more aggressive and competitive, offering better terms for dividend recaps.

Impact on Enterprise Software Companies

Enterprise software companies are particularly well-suited for dividend recaps due to their strong cash flows, high valuations, and growth potential. These characteristics make it easier for them to service the additional debt taken on for dividend recaps.

Case Studies and Examples

1. Clearlake Capital Group: Clearlake executed a significant dividend recap for one of its portfolio companies, leveraging the company’s strong cash flows and high valuation to return capital to investors.
2. IK Partners: IK Partners sold a 50% stake to Wendel, a French investment firm, and used the proceeds to pay a dividend to its equity holders, including CEO Christopher Masek.

Expert Insights

Industry experts have provided valuable insights into the resurgence of dividend recaps and their implications:

• Lincoln International: According to Lincoln International, the number of dividend recap transactions increased in 2023, and this trend is expected to continue into 2024. They attribute this to better terms from private debt funds and a lack of new platform acquisitions.
• Rupert Bell, PER: Bell emphasizes the importance of improving the operating model in the current private equity landscape, as traditional drivers of carried interest have become harder to achieve.

Risks and Considerations

While dividend recaps offer several benefits, they also come with risks:

1. Financial Distress: If a company is unable to service the additional debt, it may face financial distress or bankruptcy. This can lead to litigation, with shareholders or creditors alleging that the dividend recap was a fraudulent conveyance.
2. Solvency Opinions: To mitigate these risks, companies often obtain solvency opinions from qualified investment banks. These opinions assess whether the company will remain solvent after the dividend recap and can help protect directors and officers from personal liability.

Conclusion

The decline in carried interest has driven private equity firms to adopt dividend recapitalizations as a strategy to generate returns. This trend is particularly evident in the enterprise software sector, where companies’ strong cash flows and high valuations make them ideal candidates for dividend recaps. While these transactions offer a way to return capital to investors without selling portfolio companies, they also come with risks that need to be carefully managed.As the private equity landscape continues to evolve, dividend recapitalizations are likely to remain a key tool for generating returns. By leveraging expert insights and robust risk mitigation strategies, private equity firms and their portfolio companies can navigate these challenges effectively and capitalize on the opportunities presented by this growing trend.In the words of Rupert Bell, “Improving the operating model is now paramount,” highlighting the need for private equity firms to adapt and innovate in their approach to generating returns. As the industry evolves, dividend recapitalizations will likely remain a key tool in the private equity playbook, particularly for enterprise software companies with strong cash flows and growth potential.

Also published on Medium.