Meaning, Benefits, and Drawbacks of Leveraged Recapitalization

The Meaning of Leveraged Recapitalization

Leveraged It’s a business strategy that restructures the firm’s capital structure. The corporation takes on more debt as part of a reorganization, which results in an increase in available funds. Instead of investing the funds in new or current projects, the company chooses to either pay out huge dividends or buy back its own stock, depending on the situation. As a result, a company’s capital structure is altered in that equity is reduced while debt is increased. Senior or mezzanine debt may be structured for the new debt. In most cases, this refinancing method is used by privately owned businesses.

Such a plan prepares the company for an era of rapid expansion. Since the firm is in its early stages of expansion, a strategy that leverages debt is advantageous. In order to increase performance and shareholder value, a company might proactively employ debt. This is still the ultimate goal of the corporations.

This tactic is occasionally used by the company in order to resist or deflect any hostile takeover proposal. This is due to the fact that increasing the company’s debt would make it less attractive to a possible buyer. So it’s known as a “shark repellent” method.

If a company is defensive or aggressive, the market’s reaction to the announcement of this approach will be different. Whether or whether such a strategy increases a business’s market value also relies on how the market views the degree of risk in the new capital structure of the company (after using this strategy).

For a brief period from 1985 to 1988, the practice of leveraging a company to raise financing was widely accepted by investors. However, as a bulwark against hostile takeovers, these deals were common.

Types of Recapitalization Using Leveraged Finance

Leveraged recapitalizations may be divided into two categories based on whether or not this tactic is employed:

Leveraged Cashouts (LCO): This strategy includes paying large payouts to shareholders by leveraging the company’s debt.

When a company uses debt to buy back stock, it’s known as a leveraged share repurchase (LSR). Because fewer shares will be outstanding after the repurchase, the company’s profitability will rise as a result. In addition, even if the PE stays the same, a rise in EPS will ultimately lead to an increase in the market price of the shares.

Recapitalization Using Leveraged Finance

There are several reasons why a business can benefit from a recapitalization like this:

  • As previously said, avoiding a hostile takeover is a common tactic. Taking on additional debt for non-productive reasons makes a target firm less appealing.
  • It may also be used to expand a company’s tax shelter. A company’s net income is reduced by the interest paid on the loan. As a result, the corporation has a lower tax bill. Using the Modigliani-Miller model, we may arrive at the optimal debt-to-equity ratio for our planning purposes and maximize the tax advantage. In general, the more debt you have, the smaller your tax bill will be. The technique is more effective when the company has a large profit margin or a large amount of cash on hand.
  • This method also increases a company’s ability to borrow money. When the company’s operational expenditures are greater than its cash inflows, financial leverage is advantageous.
  • Creating crises with the goal of enforcing company-wide adjustments was part of management’s game plan all along.

The Positives and Negatives

For example, a recapitalization approach has several advantages:

  • The company’s ownership stake grows if the additional debt is used to repurchase its own shares. Consequently, it aids a company’s ability to keep ownership. There is no equity dilution despite the increase in debt since there is no change in the equity quantum. Shareholders gain nothing from a shift in control or a reduction in a company’s market power.
  • The owners often just have to negotiate with the bank, making the procedure reasonably fast.
  • This financing may be carried out secretly and without interfering with normal corporate activities.
  • The opportunity cost of a company is reduced when a loan is used to buy back shares or pay off previous debt. Due to the company’s new financial position, it will no longer be compelled by its own earnings to pay off or buy back its own shares.
  • Moreover, it will enable the company to take advantage of the current low-interest rate.

Recapitalization may lead to the following drawbacks:

  • Additional loans will be subject to security or personal guarantees from the bank.
  • The company’s financial reporting will be burdened by more debt, both senior and mezzanine.
  • Pressure on cash flows and future economic possibilities might be caused by increasing debt.
  • The capital structure of a firm will be altered if it takes on a large amount of debt. The company’s development potential might be jeopardized, and shareholder value could be destroyed as a result.
  • Depending on the company’s financial situation, further loans may have a higher interest rate than the market is now charging.

Use Leveraged Financing for Buyouts and Recapitalizations

A purchase method is known as a “leveraged buyout” (LBO) is described here. To fulfill the purchase price, a corporation takes on extra debt. Both options (LBO and Leveraged Recapitalization) provide a comparable structure and dramatically increase financial leverage. As a result, organizations using either strategy run the danger of failure if external conditions are not favorable. As a result, companies are more susceptible to a recession or other abrupt shocks.

When it comes to the pros, both systems encourage management to increase operational efficiency. This is because the corporation can satisfy interest and principal obligations by increasing operational efficiency. We can also add that the company’s management works tirelessly to guarantee that all of its debt and main obligations are met without jeopardizing the company’s future development.

After implementing these tactics, a corporation often goes through a restructuring process in which it sells off assets that are no longer useful in order to reduce its debt. Leveraged recapitalization does not need a corporation to become private, unlike LBOs.

Final Words

There are several advantages to using a corporate finance technique known as a leveraged recapitalization. Adding extra debt to a company’s capital structure in this way alters its capital structure, increasing its level of leverage. On the other hand, if the corporation is unable to satisfy its obligations (interest and principal) owing to external or internal issues, such a plan might be dangerous. This approach’s success or failure is mostly dependent on how the market or investors perceive the company’s risk level after implementing this plan.

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