Private equity funds are increasingly pushing their portfolio companies to take on more debt to return cash to investors, new Moody's Ratings analysis shows, as the usual ways of monetizing investments, public listings and sales to other buyers or funds, have dried up.
The practice, known as a dividend recapitalization, has surged since 2022. Moody's expects activity to remain high in Europe, the Middle East and Africa as private equity firms look for ways to pay out investors while company sales and IPOs stay subdued. The ratings agency estimates that private equity-owned companies in the EMEA region could take on a further 41 billion euros ($46 billion) in debt before reaching leverage levels that typically prompt a downgrade.
"The fundamental problem is that exits are few and far between," said Moody's analyst Mayank Mallik. "The European IPO markets have been muted, and the capital that would generally fund strategic purchases by large corporates has become a lot more expensive after the last rate hike cycle."
The shift means funds are now holding onto companies for much longer than the typical period of around five to six years. Distributions to investors have fallen sharply, dropping from more than 30% of starting net asset value in 2022 to about 12% today, according to PitchBook data cited by Moody's.
Moody's said sponsors have so far been "disciplined" in choosing dividend recap candidates, with services, consumer products and manufacturing the most active sectors. Most recaps have involved companies that outperformed their original business plans, with the new debt generally returning leverage to its initial level without materially affecting exit opportunities.
Still, Mallik acknowledged risks. Companies preparing for IPOs like to show a track record of solid deleveraging for a couple of years before approaching the market, he said, meaning recent recaps could leave issuers unable to jump on an unexpectedly opening IPO window. "Any company doing a div-recap is likely taking a forward-looking view that the IPO market will be closed in the short run," he said.
Moody's warned that if the exit backlog is prolonged, sponsors may start looking at relatively weaker credits to monetize, which could leave companies saddled with debt they are less able to weather.