How Do Dividend Recaps Affect IRR and MOIC?

A dividend recap generally raises IRR and lowers MOIC. IRR rises because its calculation is sensitive to timing and the sponsor gets cash earlier in a recap. MOIC falls because the recap debt has interest, and that interest reduces the cash that would otherwise have raised equity value. Both fall only in the rare case that the debt is unusually expensive, which is explained below.

What is a dividend recap?

A dividend recap is just a combination of two actions: paying shareholders a dividend and raising debt during a hold. Sponsors do dividend recaps (1) to increase IRR and (2) to return capital to LPs.

The second reason is about PE fund management instead of LBO modeling. LPs want DPI, and dividend recaps are a way to get it. Exits are hard to come by these days in PE, so recaps are a natural next-best option.

Why does a dividend recap raise IRR?

IRR is sensitive to time. The theory people learn is that IRR is the discount rate needed to set the NPV of an investment to zero. In other words, if I put $100 into an investment, how hard do I have to discount the future money for it to be worth exactly $100 today?

Suppose we’re running Cole & Company, a private equity sponsor. We’re investing in IndustrialCo. Below are four scenarios illustrating how timing and dividend recaps impact returns. In every scenario Cole & Co invests $100m in IndustrialCo. All interest figures are after tax.

Scenario 1: No Recap, Sale in Three Years

Scenario 2: No Recap, Sale in Two Years

Scenario 3: Year 2 Recap, Sale in Three Years (No Interest on Recap)

Recaps raise IRR for the same reason short hold periods raise IRR: IRR is a time-sensitive calculation. Even though the sponsor gets a total of $300M in all three scenarios, the timing of the cash received by the sponsor changes the IRR.

Why does a dividend recap lower MOIC?

A common misunderstanding is that dividend recaps raise MOIC because they raise IRR. In the real world, this is basically always wrong.

Scenario 3 explicitly states that we assume zero interest on the dividend recap’s debt, because interest expense is why dividend recaps are not MOIC-neutral. The additional interest from the recap decreases the company’s cash flows. Changes in company cash flows reach the sponsor one way or another: whether it’s sitting on the balance sheet or used to repay debt, it changes net debt and therefore equity value¹.

Scenario 4 below shows a more realistic recap scenario. MOIC is lower than the first three scenarios because of the recap debt’s interest. The IRR is still higher than the no-recap Scenario 1.

Scenario 4: Year 2 Recap, Sale in Three Years (with $10 After-Tax Interest from Recap)

All four scenarios side by side:

MOIC is 3.0x in every scenario except the one with interest expense. IRR changes in all four.

When does a dividend recap lower IRR?

A recap is accretive as long as the debt costs less after tax than the IRR you’re already earning.

At IndustrialCo’s 44% base IRR, the recap debt would need to cost 44% after tax (~59% coupon at a 25% tax rate) before IRR turns negative on the recap.

There’s a formula for the breakeven. Let $y$ be the IRR without the recap, and $n$ be the number of years the recap debt stays outstanding. The recap is IRR-neutral when the after-tax interest rate is:

Don’t memorize the formula. No interviewer is going to ask for it. The idea is what matters: a recap trades the cost of the new debt against the return your equity is already earning.

For a pre-tax coupon, divide by $(1 - \text{Tax Rate})$.

$E_0$ is the equity cheque, $V$ the exit equity without a recap, $D$ the recap debt, $r$ the after-tax rate, $T$ the exit year and $n$ the years the recap debt is outstanding. This assumes the recap debt is still outstanding at exit, interest is paid in cash each year rather than compounding, the dividend equals the full debt raise with no fees, and exit TEV is unchanged.

The size of the recap drops out. A $20m dividend and a $200m dividend break even at the same interest rate.

At IndustrialCo’s 44% base IRR:

At one year the formula reduces to $r^{*} = y$. That’s the version to remember: the recap helps IRR as long as the debt costs less after tax than the IRR you were already earning.

If the recap debt accrues rather than paying cash interest, $r^{*} = y$ for any size and any hold period.

Takeaways

The key takeaways here are simply: a recap generally raises IRR and lowers MOIC. IRR rises because of its sensitivity to time. MOIC falls because of interest expense. The interest rate that would make IRR fall is far above anything a lender charges, so what makes a recap dangerous is the added leverage rather than the arithmetic. Note that the breakeven scales with the return you already have: IndustrialCo compounds at 44%, but on a deal running at 8% the one-year breakeven is about an 11% coupon before tax, which is inside what a lender would actually charge. On a struggling hold, the arithmetic can work against you too.