A recap brings cash forward and pays for it with interest, so the rate of return and the multiple move in opposite directions, and the trade only works while the deal earns more than the debt costs.
A dividend recap raises the IRR and lowers the MOIC. On an illustrative buyout with 200.0 of equity that sells for 420.0 of equity in year 5, an 80.0 recap in year 2 lifts the sponsor's IRR from 16.0 to 17.6 per cent while the multiple falls from 2.10x to 2.01x. The recap gives up 18.92 of profit to receive cash three years earlier, and it only helps while the deal earns more than the debt costs after tax.
Worked in full in The Buyout Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A dividend recapitalisation borrows against the portfolio company and pays the proceeds out to the shareholders. Nothing about the business changes. What changes is the timing of the sponsor's cash and the size of the claim that sits ahead of the equity at exit. Both effects can be computed in a few lines, and they run in opposite directions.
| Input | Value |
|---|---|
| Sponsor equity at closing | 200.0 |
| Equity proceeds at exit, end of year 5, without a recap | 420.0 |
| Recap debt raised at the end of year 2 | 80.0 |
| Interest rate on the recap debt | 9% |
| Tax rate (interest is deductible) | 25% |
| Arrangement fees, share of the new debt | 2% |
| EBITDA in year 2 / existing debt in year 2 | 55.0 / 190.0 |
Leverage goes from 3.45x to 4.91x EBITDA on the day of the recap. That is the number the lenders will price, and the one the investment committee should see beside the IRR.
Dividend = recap debt × (1 − fees)
Claim at exit = recap debt × (1 + rate × (1 − tax))years to exit
Exit equity after recap = exit equity without recap − claim at exit
In Excel, put the three flows on a dated row (0, year 2, year 5) and run =IRR(range); the MOIC is =SUM(distributions)/equity.
Step 1, the dividend. 80.0 of new debt less 1.6 of fees pays a dividend of 78.4, which is 0.39x of the equity returned in year 2.
Step 2, the cost carried to exit. The after-tax rate is 9 per cent × (1 − 25 per cent) = 6.75 per cent, or 5.4 a year. Every unit of that interest is cash that would otherwise have repaid debt or stayed on the balance sheet, so the cost compounds. Over the three years to exit the recap debt grows into a claim of 97.32.
Step 3, the exit. Equity proceeds fall from 420.0 to 322.68.
Step 4, the returns. The sponsor now receives 78.4 in year 2 and 322.68 in year 5, 401.08 in all.
| No recap | Recap | |
|---|---|---|
| Equity invested | 200.0 | 200.0 |
| Distribution, year 2 | 0.0 | 78.4 |
| Distribution, year 5 | 420.0 | 322.68 |
| Profit | 220.0 | 201.08 |
| MOIC | 2.10x | 2.01x |
| IRR | 16.0% | 17.6% |
The recap adds 1.6 points of IRR and costs 18.92 of profit. Both figures are right; they answer different questions. The IRR treats the 78.4 received in year 2 as if it were reinvested at 17.6 per cent, and the sponsor has no such investment waiting. The multiple says the owners of this company end up with less money than if they had left the balance sheet alone, because 18.92 went to the lenders and to fees.
For a fund, the recap also produces DPI before exit and returns capital that stops the preferred return compounding. That is why it is attractive late in a holding period, and why investors read a recap-boosted IRR next to the multiple. The relationship between the two is worked in how to convert MOIC to IRR.
| Variant | Leverage after recap | MOIC | IRR |
|---|---|---|---|
| Recap of 40 in year 2 | 4.18x | 2.05x | 16.7% |
| Recap of 80 in year 2 (base) | 4.91x | 2.01x | 17.6% |
| Recap of 120 in year 2 | 5.64x | 1.96x | 18.7% |
| Recap of 80 in year 1 | 1.97x | 18.7% | |
| Recap of 80 in year 4 | 2.06x | 16.3% | |
| Recap of 80 at a 12% rate | 1.97x | 17.2% |
The bigger and earlier the recap, the higher the IRR and the lower the multiple. The variant that matters most is the weak exit.
| Exit equity | MOIC, no recap | IRR, no recap | MOIC, recap | IRR, recap |
|---|---|---|---|---|
| 420 | 2.10x | 16.0% | 2.01x | 17.6% |
| 300 | 1.50x | 8.4% | 1.41x | 8.7% |
| 240 | 1.20x | 3.7% | 1.11x | 2.6% |
The break-even rule: a recap raises the IRR only while the deal's own return is above the after-tax cost of the recap debt, here 6.75 per cent plus the fees. At an exit of 240 the deal earns 3.7 per cent, so the sponsor has borrowed at a higher rate than its investment earns, and the IRR falls to 2.6 per cent. The recap is a bet that the deal will beat its debt.
The common mistake is to present the higher IRR as value created. A recap creates no enterprise value: it moves cash forward and transfers some of it to lenders. The second mistake is to ignore the compounding of the after-tax interest. Charging only the 80.0 of principal against the exit overstates exit equity by 17.32 and makes the recap look nearly free. And because the company steps up to 4.91x of leverage and carries the extra 80.0 of debt for the rest of the hold, a bad year that the original structure would have absorbed can now trip a covenant.
Model the recap as three flows: the dividend net of fees, the debt compounded at its after-tax rate to exit, and the reduced exit equity. On this deal the IRR rises from 16.0 to 17.6 per cent and the MOIC falls from 2.10x to 2.01x, and the trade turns against the sponsor whenever the deal earns less than 6.75 per cent. The book's own recap scenario is a complete live case in the free workbooks for The Buyout Investor, and the LBO model template lets you add a recap year to your own deal.
The IRR rewards cash received early, and the recap pays 78.4 back in year 2 instead of year 5. The MOIC counts only total dollars, and the recap reduces them: the new debt and its after-tax interest, 97.32 by exit on the illustrative deal, are repaid from the sale proceeds. Profit falls by 18.92 while the IRR rises 1.6 points.
When the deal's return falls below the after-tax cost of the recap debt plus its fees. At a 9 per cent rate and 25 per cent tax that cost is 6.75 per cent. A deal that exits at 240 of equity earns 3.7 per cent without the recap and 2.6 per cent with it, so the recap borrowed at a higher rate than the investment earned.
Yes. The dividend is a realised distribution, so an 80.0 recap that pays 78.4 after fees on 200.0 of equity returns 0.39x of paid-in capital years before exit. That is why recaps are common in the later years of a fund's investment period, when limited partners and the next fundraise both look at DPI.
This article is one calculation from The Buyout Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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