The dividend debate

Can dividend recapitalizations sink sponsor-backed companies into bankruptcy? The answer has so far eluded many, largely because the empirical evidence has been scant.

The debate has simmered ever since private equity firms began using this nifty mechanism to extract value from their leveraged buyouts. From 2004 to the second half of 2007, an estimated $86 billion in sponsored dividend recaps were reported by Standard & Poor's.

About a year ago, ratings agency Moody's Investors Service had taken the view that a sponsor's track record on dividend recaps would have an impact on the way it rates a sponsor's portfolio companies. But it warned that the "litmus test" will take place only over the next several years as these companies fall on hard times under a much tougher credit environment.

Apparently, the recent spike in defaults and bankruptcy filings may provide sufficient data sooner than expected. Moody's is revisiting the issue, but this time hopes to arrive at some answers.

"We're going back to tracking dividend recaps, and we're looking to draw some conclusions," says John Rogers, senior vice president at Moody's.

Examples abound, but the agency might take a closer look at Noranda Aluminum Holding Corp., a Franklin, Tenn., aluminum producer that Apollo Management LP bought in May 2007 for $1.15 billion. With aluminum prices coming under intense pressure and end markets suffering, Noranda's had a rough time of late. Fourth-quarter adjusted Ebitda plunged 85%, to $9.3 million, partly due to lost output from a smelter in New Madrid, Mo., caused by a severe ice storm in January that resulted in a power outage.

As of the end of 2008, Noranda held $1.3 billion of debt. Despite drastic cost-cutting measures announced in December, its Ebit is barely covering interest expenses, according to Moody's.

In its January report, Moody's singled out Apollo as one of the "most aggressive" PE firms in taking dividends, along with a few others. In the case of Noranda, Apollo rewarded its shareholders, including itself, with $216.1 million in cash payouts in June 2007, a month or so after the LBO closed. This was followed by a further $102.2 million in dividends in June 2008. Apollo, which invested $214.2 million at the time of the deal, was hoping to generate more gains after taking the company public sometime last year, but the initial public offer never materialized.

Manhattan foodies may not want for gourmet grocers in trendy neighborhoods, but the closing of Balducci's flagship high-end stores in the city--one in Chelsea and the other on the Upper West Side--has left denizens bemoaning their loss. Balducci's private equity owner, Irving Place Capital, formerly Bear Stearns Merchant Banking, said it is also closing its stores in Washington and Ridgefield, Conn. The chain, a longtime mecca for the city's epicures, says it has sold the remaining locations to an investor group led by retail veteran James Demme and a senior adviser at Angelo, Gordon & Co. "It's economic," says Irving Capital spokesman Michael Doppelt. "We're in a tough environment, and gourmet foods are not necessarily what people are flocking to."

Irving Place acquired the stores in November 2003 from AEA Investors Inc., stoking hopes among local patrons for a bigger and better Balducci's after the original Ninth Street store in Greenwich Village closed down that same year. The flagship outlet finally reopened in December 2005, and did so in lavish style. It was housed in an 8,000-square-foot facility in an elegant, century-old bank building, dispensing an array of cheeses, exotic seafood and white truffles flown in from Italy at $2,800 a pound.

But even with nearly $100 million in sponsor equity, Balducci's efforts to revive the "temple of food," as Irving Capital CEO John Howard once envisioned it, didn't hold up well against tough competition. The recession hadn't helped. Balducci's was unique in the early years, but it was fighting a losing battle in a changing market for specialty grocers.