Making Money the Old-Fashioned Way: By Looting It

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Matt Taibbi has a big cover story in the current issue of Rolling Stone that’s all about the Bain Capital business model. As you might guess, Taibbi is a wee bit critical. Dan Primack offers an assessment of Taibbi’s piece here, and spends a few words responding to Taibbi’s disgust with “dividend recaps”:

TAIBBI: In the Bain model, the actual turnaround isn’t necessary. It’s just a cover story. It’s nice for the private equity firm if it happens, because it makes the acquired company more attractive for resale or an IPO. But it’s mostly irrelevant to the success of the takeover model, where huge cash returns are extracted whether the captured firm thrives or not.

PRIMACK: This just isn’t true. The reference here is to dividend recaps, a noxious private equity practice through which firms can actually generate profits off of investments in portfolio companies that later go bankrupt. But the reality is that, for the most part, dividend recaps alone do not generate the types of returns that bring limited partners back for follow-on funds. Moreover, too many post-recap failures and banks are unlikely to make new loans to fund a private equity firm’s future deals (original LBOs or recaps). In other words, the more legitimate wins matter, so long as the private equity firm wants to stick around.

I would very much like for someone to devote an entire deep dive to this specific issue. Dividend recaps, which Primack agrees are “noxious,” are basically a way for private equity firms to suck money out of a company long before they’re turned it around. Basically, they force the target firm to take on a huge debt load (sometimes more than once) and then use a chunk of the borrowed money to pay dividends back to the private equity investors. Bain Capital did this fairly aggressively in at least a few cases, which allowed them to avoid big losses even on companies that eventually failed.

I think that Primack’s criticism of Taibbi is basically right: dividend recaps aren’t the primary way that PE firms make money from the companies they take over. The bulk of their profits come from successful turnarounds. At the same time, I suspect that Primack is underplaying the important of dividend recaps. What they do is limit losses on failed acquisitions. If you buy ten companies, and end up with five successes and five failures, you’ll make money, but perhaps not spectacular amounts of money. However, if you buy ten companies and end up with five successes and five breakevens, thanks to the dividends you extracted from the target firms, your rate of return will be a lot higher. It might be the difference between a 10% rate of return and a 30% rate of return.

At least, that’s my sense of things. But I’d love for someone to write a really detailed piece about this, with particular attention to how aggressively Bain Capital engaged in dividend recaps and how critical they’ve been to its success. This Reuters piece from January is a start, but it’s only about one particular deal. It would be interesting to know just how widespread this practice was and how big a difference it made to Bain’s bottom line.

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