The IPO drought is driving private equity-owned companies to the debt market to pay investors

Private equity funds are increasingly pushing their portfolio companies to take on more debt to return cash to their investors, data suggests.

It comes as the typical ways of monetizing private equity investments — selling company stakes via IPOs, or offloading them to other PE funds or buyers — have dried up in recent years.

While investors get paid, the practice of private equity sponsors adding more debt to companies — known as dividend recapitalizations — risks weakening their ability to invest or weather future downturns in trading.

"Dividend recap" activity has surged since 2022, and Moody's Ratings expects it to remain high in Europe, the Middle East and Africa as private equity firms look for ways to return money to investors while company sales and IPOs remain subdued.

The ratings agency estimates that private equity-owned companies in the EMEA region could take on a further 41 billion euros ($46 billion) in debt before reaching leverage levels that typically prompt a downgrade.

New Moody's analysis indicates the practice remains limited to the strongest-performing companies with the greatest capacity to take on new debt, indicating this "significant releveraging capacity" could support a further ramp-up in dividend recaps.

Still, it does not address the exit backlog weighing over private equity, where funds are now having to hold onto companies for much longer than the typical period of around five to six years.

"The fundamental problem is that exits are few and far between – the European IPO markets have been muted, and the capital that would generally fund strategic purchases by large corporates has become a lot more expensive after the last rate hike cycle," said Moody's analyst Mayank Mallik. "Generally, we are more focused on the impact that the general PE ecosystem has on corporate credit quality — and this is one of the key transmission mechanisms currently."

Moody's said PE sponsors have remained "disciplined" in choosing dividend recap candidates, with services, consumer products and manufacturing the most active sectors.

Mallik noted most dividend recaps have involved companies that outperformed their original business plans, with the new debt generally returning leverage to its initial level without "materially" affecting exit opportunities.

"It is true, however, that companies preparing for IPOs like to show a track record of solid deleveraging for a couple of years before approaching the market," he told CNBC via email.

"There is indeed a risk that, if an IPO window unexpectedly opens, issuers that have recently done a div recap may not be able to jump on the opportunity. Any company doing a div-recap is likely taking a forward-looking view that the IPO market will be closed in the short run."

Distributions to investors have fallen sharply in recent years. Moody's, citing PitchBook data, said private equity distributions dropped from more than 30% of starting net asset value in 2022 to about 12% today.

"The risk is that if PE exit backlog is prolonged, sponsors may start looking at relatively weaker credits to monetize, which may lead to credit deterioration across the portfolio," Mallik added.

He said that those risks are greater than a decade ago, partly because documentation has become "quite permissive" for issuers looking to raise additional debt.

Portfolio companies' recaps are typically funded through the broadly syndicated loan market, where several investment banks will club together to lend money to a borrower, thereby spreading the risk. Alternatively, funding is raised by high-yield corporate bond issuance or private credit borrowing.

Sunaina Sinha Haldea, global head of private capital advisory at Raymond James, said there is still "meaningful capacity" to fund recaps, highlighting how tight spreads and scarce new loan supply are helping support appetite.

"Weaker earnings, wider spreads or investor withdrawals could tighten availability, while a recovery in acquisition financing would give lenders more alternatives to funding shareholder payouts," she said.

Haldea noted that dividend recaps provide liquidity, relieving the pressure to sell without ultimately resolving the valuation gap.

"Investors get some cash back, but the asset remains in the fund and still needs an eventual buyer," Haldea told CNBC via email.

"A dividend recap need not derail an exit if earnings growth has created genuine borrowing capacity, but borrowing against hoped-for growth is a different proposition. More debt means less financial flexibility and, at the same enterprise value, less equity value left for shareholders when the business is eventually sold."