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Can Europe kill the dividend recap?

October 31, 2012: 2:29 PM ET

EU rule could change the private equity landscape.

FORTUNE -- Private equity firms are about to have a much tougher time making money in Europe, and I'm not talking about the ongoing debt crisis.

Beginning in July, private equity firms will not be allowed to transact dividend recaps for EU-based portfolio companies during the first two years of control. This comes as part of the Alternative Investment Fund Managers (AIFM) directive, a byzantine set of rules passed last year by busybody European politicians who couldn't figure out how to address the Continent's actual economic issues.

Look, I generally dislike dividend recaps -- situations in which PE firm lard more debt onto portfolio company balance sheets in order to pay themselves a "dividend" (a term that usually is reserved for profit-based payments). They can skew alignment of interests, imperil otherwise-healthy companies and make a mockery of private equity's "value creation" claims. Moreover, they can provide limited partners with short-term cover at the expense of long-term gains. But there is a big difference between finding something wrong-headed and outlawing it.

Moreover, the rule could help dissuade private equity firms from doing business in Europe. Even if you are in the camp that doesn't believe private equity generally helps create jobs or economic growth, it's impossible to deny its value as a flexibility tool for companies seeking strategic alternatives (even if only as a pawn used to drive up the purchase price for strategic buyers).

But back to what the AIFM actually says. The dividend recap piece is within a section on "asset stripping," but the only "assets" mentioned are company shares. From the directive:

Member States shall require that when an AIF, individually or jointly, acquires control of a non-listed company or an issuer pursuant to Article 26(1), in conjunction with paragraph 5 of that Article, the AIFM managing such an AIF shall for a period of 24 months following the acquisition of control of the company by the AIF:

(a) not be allowed to facilitate, support or instruct any distribution, capital reduction, share redemption and/or acquisition of own shares by the company; (b) in so far as the AIFM is authorised to vote on behalf of the AIF at the meetings of the governing bodies of the company, not vote in favour of a distribution, capital reduction, share redemption and/or acquisition of own  shares by the company; and (c) in any event use its best efforts to prevent distributions, capital reductions, share redemptions and/or the acquisition  of own shares by the company.

In other words, a private equity firm cannot recoup capital via adding extra debt onto the company or by having the company repurchase shares for a two year period after the PE firm acquires control.

A few caveats: First, small and mid-sized businesses – those that employ fewer than 250 people in the EU and less than €50m in annual revenue – are exempt. Likely an exemption without impact, since SMEs are rarely the subject of PE-sponsored dividend recaps.

Second, private equity firms still can pay dividends to limited partners, so long as those dividends come from profits.

Third: There seem to be no restrictions on a company adding new debt for the sake of increased balance sheet flexibility. Nor is there a restriction on a PE firm from selling to company to another PE firm and, in the process, increasing the company's leverage load.

Finally, it should be interesting to see if PE firms try to game the system by conducting a dividend recap within the first two years of ownership, and then simply putting the LP proceeds in escrow until the period expires. I'm sure such a thing would be challenged but, from reading the rules, I'm not so sure it's prohibited.

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Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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