Recapitalization — Types and Benefits
A form of corporate restructuring, recapitalization aims to change a company’s capital structure, typically to make it optimal or stable. It entails exchanging one type of financing for another.
Recapitalization broadens the company’s financing options so that they do not rely solely on existing financing sources. The company can also pursue different recapitalization strategies, and customize structures with various financial partners to fit unique requirements and meet liquidity objectives.
Companies also undergo recapitalization to raise capital for growth or expansion. Despite a positive cash flow, rapidly growing companies may face capital constraints when attempting to increase production capacity or hire additional employees. In this case, companies can engage with venture capital firms or angel investors to raise funds through debt or equity. For larger and more stable companies, recapitalization allows them to acquire competitors or pursue another strategic interest to increase equity value for shareholders.
A recapitalization is also an option for companies that want to reduce interest on the debt by replacing high-interest with low-interest debt instruments. For instance, a company can issue callable bonds that they can take back should the interest rates increase, and then issue stock to raise the needed funds.
One type of recapitalization is leveraged recapitalization, through which the company replaces part of its equity with additional debt as a result of a declining share price. One way companies exercise this is to raise money by issuing bonds. In doing so, the company controls the fall in share price by reducing the outstanding shares in the market. Supply and demand forces will typically increase the company’s earnings per share and stock price.
Under leveraged recapitalization is a leveraged buyout initiated by a third party. The third-party purchases a company using a significant amount of debt to meet the cost of the acquisition. The third party also uses the company’s cash flow as collateral to secure and repay the debt. Because of the nature of the buyout, the capital structure of the target company changes as the debt-to-equity ratio increases significantly.
Dividend recapitalization is another type of leveraged recapitalization. A company issues new debt and uses the money to pay a special dividend to shareholders, reducing the company’s equity-to-debt ratio. Essentially, the newly incurred debt (and not the company’s earnings) becomes the source of dividends distributed to the shareholders. Besides avoiding using earnings for dividend payout, companies undergo dividend recapitalization to exit an investment or when an investor wants to recover its initial investment without necessarily losing its shares in a company.
Meanwhile, equity recapitalization allows a company to issue new equity shares to raise money to repurchase debt securities. Companies with a high debt-to-equity ratio benefit from this strategy, as failure to do so means incurring interest on their debt securities. High debt levels also translate to high-risk levels, making the company less attractive to investors. To reduce the debt burden, new shares are issued that generate additional capital which is used to pay down some of the current debt.
Under equity recapitalization is nationalization, through which a government entity purchases a significant number of the company’s shares to obtain a controlling interest. Generally, a company undergoes recapitalization when a government wants to take over the assets of a profitable private company — usually a foreign business — with a substantial operation within the country. However, a government may also buy shares when a company on the brink of a potential bankruptcy is considered valuable to the country’s economy. Companies may also undertake nationalization when a government wants to seize any illegally acquired assets.
