Higher interest rates challenge LBO exits
To combat the inflationary surge seen during 2021–2022, central banks rapidly and significantly in-creased interest rates: the US Federal Reserve raised them 11 times between March 2022 and July 2023, from 0% to a range of 5.25%–5.5%. This had a major impact on private equity firms that typically rely on debt to acquire companies through leveraged buyouts (LBOs). Not only did new investments slow down, but the ability to exit these investments, by selling companies or taking them public, also decreased significantly.
With fewer successful exits, private equity firms found it harder to return profits to their investors, who in turn became reluctant to commit fresh capital to new funds. Facing mounting pressure to generate returns, many fund managers turned to an alternative tactic known as a "dividend recapitalisation." This involves taking a portfolio company that is already owned, loading it up with additional debt, and using the borrowed funds to pay out a large dividend — often to the private equity firm and its investors. While technically legal and financially appealing in the short term, this move increases the company’s financial burden and reduces its ability to weather future challenges.
A cautionary tale: The dividend recapitalisations of KB Toys and Phones 4u
The trend accelerated in 2024 and 2025 as borrowing costs started to fall, making it easier and cheaper to execute such transactions. By mid-2025, the average dividend recapitalisation had reached $350 million, with a total of $21 billion distributed through this method — a significant jump from the year before. On the surface, the debt levels appeared manageable, with average leverage sitting around 4.8 times earnings (EBITDA), well below historical peaks. However, behind these reassuring averages lie troubling stories that reveal deeper risks. Two notable cases — KB Toys in the United States and Phones 4u in the UK — illustrate how dividend recaps can weaken companies at critical moments. In both instances, private equity owners extracted substantial cash just before the companies faced major operational setbacks. KB Toys, after receiving an $85 million dividend payout in 2002, entered bankruptcy in 2004 amid declining mall traffic and heavy debt. Similarly, Phones 4u completed a £200 million dividend recap in 2013, only to face contract terminations with major telecom providers shortly afterwards, culminating in collapse and mass store closures in 2014.
More concerning was the apparent withdrawal of active involvement from the fund managers after the payouts — a sign that their incentives had shifted. Once the capital was returned, the urgency to nurture or strategically guide the business faded. In essence, the private equity sponsors no longer had sufficient "skin in the game," breaking the alignment between owners and the companies they controlled. While dividend recapitalisations offer a tempting solution to short-term pressures, these examples serve as warnings: extracting value too soon can jeopardise long-term survival, harm employees and stakeholders, and ultimately damage trust in the private equity model. As the pace of such transactions accelerates, vigilance is required to ensure that quick wins do not come at the expense of lasting value.
The risks of dividend recapitalisations
Despite low and stable leverage ratios both pre- and post-dividend, the significant increase in volumes of dividend recapitalisations and compression of spreads could indicate a risk of overheating. One of the primary criticisms of dividend recapitalisations is that the re-leveraging of transactions introduces additional risks that are not adequately mitigated, particularly through the implementation of a new value creation plan in the target company. As a result, deals can be overleveraged and ultimately fail. This was the case with KB Toys and Phones 4u.
Therefore, the targets of dividend recapitalisations are larger, which means that their impact reverberates more strongly in private equity. At first glance, the failure rate of dividend recapitalisations is half than for LBOs. However, these failure rates could be significantly underreported, it is also difficult to draw effective conclusions on the riskiness associated with dividend recapitalisations.