The market continues to surprise us... for the wrong reasons.

If you've been following our market coverage, you know companies scrambled to issue debt back in January.

Many had put it off for months, hoping they could wait for interest rates to fall. But as it became clear that wouldn't happen, a lot of businesses caved to their looming debt maturities... and decided to refinance.

Companies issued $125 billion in speculative-grade debt in one month. It was the highest level since right before the pandemic.

We hoped companies would use their debt for productive reasons. But it seems they had other ideas... particularly those backed by private equity ("PE"), which used it as a final cash grab instead.

And their greed will only make the eventual downturn worse.

Regular readers know there are two key ways companies use credit...

The first way is to help them grow their businesses. And the second is to refinance their debts... helping them avoid bankruptcy.

But there's a third way that much of the market disregards – until it comes back to bite them.

We're talking about dividend recapitalizations. That's when a company borrows a lot of cash... but instead of using it to pay down old debt or finance growth, it returns that money directly to shareholders.

When interest rates are low – like when they were near zero in 2021 – this is a shrewd strategy. Shareholders love it, and the business can afford to take on a little extra debt.

However, while dividend recaps benefit equity investors in the short term... they also increase leverage on the business.

As rates jumped over the past two years, dividend recaps fell out of favor...

But high rates also dragged down deal volume and made initial public offerings far less appealing. So it got a lot harder for PE firms to close out investments.

And they've been under a lot of pressure to find new ways to compensate hungry investors.

With the Federal Reserve hinting at three rate cuts in 2024, PE firms started to reconsider their options. Dividend recaps surged in January... Companies took on more than $8 billion worth of loans for this purpose alone.

That's double the volume of any month in 2023, and the highest volume since November 2021.

Even though companies are borrowing, they aren't getting much safer...

Since PE firms own their portfolio companies, they have a lot of control over how much they borrow... and what it gets used for. They aren't doing those companies any favors by using them as piggy banks.

Investors may be happy to get their cash. But the companies borrowing that debt are even worse off than they were. They don't get to keep any of that extra cash. And now, they're on the hook for high interest payments and the principal.

It may not happen immediately... but once companies start going bankrupt, this trend could make the problem a lot worse. Companies won't be able to keep borrowing forever, especially if banks know the money is just going to investors.

It seems like PE firms are simply delaying the inevitable risk of bankruptcy. Debt is expensive today. Companies need to use it carefully.

And if January was any clue as to how PE firms are treating debt today... it's cause for serious concern.


Rob Spivey
March 6, 2024