Dr. Dre's Prescription: A Big Dividend Loan

Beats Electronics LLC, Dr. Dre's high-end headphones company, is looking to raise up to $650 millionin corporate loans. But for the most part, Beats won't use the money to build new factories, hire salespeople, or ink (more) celebrity endorsement deals. Instead, Beats wants the money... to pay Dre and his co-owners a dividend.

Dre and his corporate posse won't get to pocket all $650 million, of course. About a third of the money will go to roll over $225 million worth of the company's existing debt. However, the balance -- $400 million and change -- will go to acquisitions, investments, share repurchases,and "distributions to shareholders" (i.e., dividends).

About $150 million will be earmarked for the latter, with the majority of these dividends going to Taiwanese smartphone maker HTC. HTC is currently Beats' top shareholder, with a 25.1% stake in the company. The rest will go to fellow shareholders that include Access Industries, Geffen A&M Chairman Jimmy Iovine, and of course, Dr. Dre himself.

Open season on the cookie jar
Nor will they be alone. According to Bloomberg, the phenomenon of corporate insiders "raising loans through companies they own to pay themselves dividends" is a hot new trend. It's especially popular among private equity owners. A few examples:

• During the three years in which Blackstone Group (BX +0.00%) owned SeaWorld (SEAS 0.01%), before IPOing it earlier this year, the private equity firm heaped $400 million in new debton the company -- and paid itself in excess of $600 million worth of "special" dividends.
• Petco has been taken private twice already (and re-IPOed once), getting loaded up with debt each time. A couple of years ago, private equity owners TPG Capital and Leonard Green & Partners took out more than $1.2 billion in loans to pay themselves a near-$700 million special dividend.
• Yankee Candleis aiming to raise $1.4 billion later this year and, like Beats, says it will use some of the money to roll over old debt and some more to pay its private equity owner, Dearborn Partners, a $187 million dividend.

The $700 million question
So, clearly, the trend is popular, but why is it popular? Why are all these companies taking on debt to pay themselves dividends, knowing the debt will eventually come due and they'll have to pay it back?

Well, first and foremost, debt is cheap today. You don't have to pore over 10-year Treasury bill rates to understand this. A simple glance at the cost of mortgage loans these days will show you that while rates have been inching back up, they're still at historically low levels.

Second, let's continue the housing analogy. Say you own a home and you want to raise some cash. One way to do this is to take out a home equity loan, using your home as collateral -- but adding to your debt. This was a very popular scheme circa 2007.

Companies do basically the same thing when they take out a loan and use it to pay themselves big dividends. It beats the alternative, which would be an owner selling some of its shares -- getting cash but reducing its ownership stake and perhaps even losing control of the company.

The $700 million risk
There is, however, danger in this. Much like a homeowner who takes on too much debt when "taking cash out" of a subprime mortgage, a company that takes on too much debt to pay its owners a big dividend can be setting itself up for a fall.

Indeed, this may be happening at Beats. Reviewing the proposed issuance, Moody's recently gave the debt a speculative B2-rating. Moody's warned that Beats' taking on debt to fund a dividend held particular risk because the company depends on just one "product offering" for its revenues, because it relies heavily upon its founders' popularity to sell its product, and because "the sustainability of the company's revenue and earnings growth" is questionable "given its very limited operating history and high business risk."

In particular, the debt rater warns that "it is unclear whether or not Beats can refresh and relaunch its products successfully as they approach their life cycles in light of fierce competition." Taking on debt to pay its owners dividends, rather than invest the cash in R&D and new product development, won't help that situation.

On the other hand, if Beats does dig itself into a deep hole, it can always IPO... and hope investors will bail it out.