The Rise of PE-Backed Dividend Recapitalizations in Enterprise Software Companies

In recent years, the private equity (PE) landscape has undergone significant transformations, with a notable trend emerging in the enterprise software sector: the increasing prevalence of dividend recapitalizations. This shift is largely driven by the decline in carried interest, which has traditionally been a significant source of income for PE professionals. This article explores the reasons behind this shift, its implications for the industry, and provides insights from experts in the field.

The Decline of Carried Interest

Carried interest, once a lucrative performance fee for private equity managers, has seen a marked decline due to several factors:

1. Increased Competition: Rupert Bell of Private Equity Recruitment (PER) notes, “The level of competition for deals has gone through the roof and the three drivers for how private equity firms make money — favorable entry multiples, a change in the profit stream and deleveraging, have all become harder to achieve. Improving the operating model is now paramount.”
2. 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 of $400 million in the second quarter of 2024.
3. Taxation Changes: In the UK, carried interest is now taxed as income rather than capital gains, potentially reducing net earnings for PE professionals by £188,000 per recipient.

Given these challenges, the appeal of carried interest is dwindling. Instead, senior professionals in private equity are increasingly seeking equity in the general partnership, which can be highly lucrative and continues to be taxed as capital gains. This shift has driven PE firms to adopt alternative strategies, such as dividend recapitalizations, to generate returns.

Understanding Dividend Recapitalizations in Private Equity

Dividend recapitalization, often referred to as a “dividend recap,” is a financial strategy where a company takes on additional debt to pay a special dividend to its shareholders, typically the private equity owners. This technique has gained popularity among PE firms, especially those invested in enterprise software companies, as it allows them to extract value from their portfolio companies without selling their stake.

Key Components of PE Dividend Recaps:

1. New Debt Issuance: The portfolio company borrows money, usually through leveraged loans or bonds.
2. Dividend Distribution: The borrowed funds are used to pay a large, one-time dividend to the PE firm.
3. Increased Leverage: This process increases the company’s debt load but allows the PE firm to recoup some or all of its initial investment.

The Surge in Enterprise Software Dividend Recaps

The enterprise software sector has seen a notable increase in dividend recapitalizations over the past two years. Here are three recent examples:

1. Clearlake Capital’s Recap of Symplr (2023): Clearlake Capital Group executed a significant dividend recapitalization for Symplr, a healthcare operations software company, leveraging its strong cash flows and high valuation.
2. Thoma Bravo’s Dividend Recap of Planview (2022): Thoma Bravo, a leading software-focused PE firm, completed a dividend recapitalization for Planview, an enterprise software company specializing in portfolio and work management solutions.
3. Vista Equity Partners’ Recap of Apptio (2023): Vista Equity Partners executed a dividend recapitalization for Apptio, a provider of technology business management software, demonstrating the continued appeal of this strategy even in a higher interest rate environment.

Factors Driving the Growth of Enterprise Software Dividend Recaps

Several factors have contributed to the rise of dividend recaps in the enterprise software sector:

1. Strong Cash Flows: Enterprise software companies often have predictable, recurring revenue streams, making them ideal candidates for additional leverage.
2. High Valuations: The software sector’s high valuations allow companies to borrow significant amounts relative to their earnings.
3. Limited Exit Options: With IPO and M&A markets facing challenges, dividend recaps offer an alternative way for PE firms to return capital to investors.
4. Competitive PE Landscape: As Rupert Bell of Private Equity Recruitment notes, “The level of competition for deals has gone through the roof,” pushing firms to seek alternative strategies for generating returns.

Risks and Considerations for PE Firms and Portfolio Companies

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

1. Increased Debt Burden: The additional leverage can strain the portfolio company’s finances, especially in economic downturns.
2. Litigation Risk: In case of financial distress, shareholders or creditors may allege that the dividend recap was a fraudulent conveyance.
3. Regulatory Scrutiny: As these transactions become more common, they may attract increased attention from regulators.

Expert Insights on the Trend

Industry experts have provided valuable insights into the rise of dividend recaps in enterprise software:

• Rupert Bell, PER: “Improving the operating model is now paramount,” highlighting the need for PE firms to focus on value creation beyond financial engineering.
• Lincoln International Report: The number of dividend recap transactions increased in 2023, with expectations for this trend to continue into 2024, driven by better terms from private debt funds and a lack of new platform acquisitions.

Conclusion: The Future of PE-Backed Dividend Recaps in Enterprise Software

As the private equity landscape continues to evolve, dividend recapitalizations are likely to remain a key tool for generating returns, particularly in the enterprise software sector. PE firms must carefully balance the potential benefits with the associated risks, ensuring that these transactions create sustainable value for both investors and portfolio companies.For enterprise software companies and investors alike, understanding the dynamics of dividend recaps will be crucial in navigating the changing PE landscape. As the industry adapts to new market conditions and competitive pressures, we can expect to see continued innovation in how PE firms generate returns and manage their portfolio companies in the software sector.

Originally published at Development Corporate.