Don't let dividend traps trip you up - Gulf Business
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Don’t let dividend traps trip you up

Don’t let dividend traps trip you up

Can’t see the return on your investment? You need to unlock value and release trapped cash to shareholders, writes a PwC executive

In the last 24 months the regional and global economies have shown signs of recovery – despite the recent slump in oil prices we have seen growth of 97 per cent in the Dubai Financial Market, 22 per cent in the Tadawul and the London FTSE recently broke the 7,000 points barrier
for the first time.

As groups return to profitability, this often triggers expectations from shareholders that they will start receiving these profits in the form of cash dividends. Often, however, a “dividend trap” will be a fundamental barrier that prevents a group from returning value to its shareholders.

Firstly what is a ‘dividend trap’ and what causes it? The recent financial crisis resulted in financial pain for many regional and global investors. Falling asset values often triggered accounting impairment of assets – especially of those assets acquired at the peak of the market.

Companies ordinarily need positive retained earnings in order to pay dividends and where these impairments depleted those retained earnings it forced a number of groups to suspend dividend payments. While many of these groups have recently returned to net cash and profit generation, the recent profits are often not sufficient to fully absorb those previously accumulated accounting losses. This scenario is known as a ‘dividend trap’ where a group is net cash and profit generative but cannot lawfully pay a dividend due to accumulated accounting losses.

Dividend traps impact a variety of stakeholders. Firstly, it may be a source of frustration and confusion for shareholders – whether individuals, corporates, family businesses, private equity investors or governments.

Having waited through the financial downturn, they can now see positive cash and profit generation but they cannot directly access this value. Depending on their objectives, this may disrupt the shareholder’s ability to redeploy cash for other opportunities or requirements.

This scenario will also invariably place pressure on the group’s senior management team to turn profits into cash dividends and meet the expectations of those shareholders on a timely basis. Additionally, deal makers may also have to think twice about entering a structure where dividend traps are presenting a medium to long-term barrier to cash extraction.

Clearly dividend traps impact the ability of shareholders to realise value and require immediate attention. Fortunately, there are
a number of restructuring options that can unlock the value of a company and facilitate the payment of dividends. These include:

• Capital reduction – this is a legal mechanism whereby an entity reduces a portion of its issued share capital in order to offset historic accumulated accounting losses, therefore eliminating the dividend trap.

• Insertion of new holding company – a new holding company will start off life with a clean slate (i.e. no accumulated accounting losses) within its entity financial statements and it may also be possible to create a pool of positive reserves available for distribution as part of the insertion of the holding company.

• Shareholder loans – often the simplest and quickest mechanism to get around a dividend trap is to lend any excess cash to shareholders. While this mechanism enables immediate cash extraction, it will leave the recipient shareholder with a liability to the company.

• Crystallisation of unrecognised value – many groups record assets at historic book values within their financial statements. Accordingly, it may be possible to crystallise unrecognised value where assets are re-measured to their fair value. Any such uplift of asset value will typically also result in a corresponding increase to equity and reserves, which may assist in structuring around a dividend trap.

It is important to note that there is not a one-size-fits all solution to this issue. Some of the above mechanisms will potentially not be viable in specific circumstances. As a result, relevant options should be considered in the context of a groups specific fact pattern and include consideration of the related accounting, legal and tax (if relevant) implications.

As companies in the region continue to return to profitability, we expect cash extraction to gain momentum and to see more groups implementing restructuring options to unlock trapped cash. Otherwise, as seen in the past, the inability to address dividend traps can act as a deal breaker in financial transactions – reflecting both the critical requirement of some investors to extract cash on a timely basis as well as the clear value derived from developing solutions to address dividend traps.


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