Lower Interest Rates Fuel Leveraged Dividend Recapitalizations for Remainder of 2024

Anticipation that rates would begin coming down from their 20-year peak has already triggered an uptick in dividend recapitalizations this year among private equity portfolio companies. The combination of lower rates, a buoyant leveraged loan market and the usual year-end rush to enhance private equity returns is likely to accelerate that trend in the fourth quarter.

The relationship between interest rates and dividend recapitalizations is nuanced. Lower interest rates reduce the cost of borrowing, making dividend recapitalizations more feasible and more attractive. But it is the expectation of future interest rate movements that is the real key and explains why dividend recapitalizations began increasing even before the Fed actually cut rates. The leveraged loan market, which provides much of the funding for dividend recapitalizations, tells the story. Leveraged loans typically include floating interest rates based on the Secured Overnight Financing Rate (SOFR). Forward SOFR rates are lower than current SOFR rates, an indicator that companies can expect to pay less interest in the future on their floating rate debt. The prospect of lower future interest rates gives private equity sponsors greater confidence that their portfolio companies can borrow additional money to pay special dividends.

Even modestly lower interest rates are likely to lead to a surge in refinancing transactions, as we’ve already seen in the mortgage market. For companies with upcoming debt maturities, using this refinancing opportunity to also pay a dividend can be an attractive proposition, especially given the number of dividend recapitalizations that were shelved as interest rates rose in 2022 and 2023.

Generally, dividend recapitalizations are more active at year-end as private equity fund managers seek to accelerate returns and boost annual performance, enhancing the attractiveness of their funds to investors. Dividends typically serve as an intermediate transactions, providing liquidity and returns before the private equity sponsors are ready to exit either through a sale, an initial public offering , or, more recently, a continuation fund transaction. With IPO and traditional M&A volumes still below historical levels, paying a dividend while waiting for traditional exit markets to rebound can make sense for private equity sponsors as long as debt capacity is available. The prospect of interest rate cuts makes that equation more favorable even as lower rates are likely to help reinvigorate IPO and M&A activity.

At Kroll’s Opinions Practice, we’re seeing those trends play out through the significant increase in the number of solvency opinion requests we’ve received for dividend recapitalizations and share buybacks.

Solvency opinions help companies and their boards of directors avoid fraudulent transfers due to illegal distributions. A solvency opinion addresses whether the fair value of a company’s assets exceed its liabilities, whether a company should be able pay its debts as they come due, and whether a company has adequate capital to operate its business.

While conditions are right for a surge in dividend recapitalizations, some caution is also warranted. Expectations of lower interest rates have risen dramatically in part because of growing concerns that the U.S. economy may be slowing, though economic data has been decidedly mixed on that score. Companies highly exposed or sensitive to a potential recession might think twice about taking on the added debt burden, even at lower interest rates, to pay dividends in an uncertain economic climate. In such an environment, solvency opinions and independent financial advice take on added importance in ensuring that boards of directors and other fiduciaries make sound decisions.