Data shows that private equity funds are increasingly encouraging the companies in their portfolios to increase debt in order to return cash to investors.

At the time this trend emerged, the common methods of realizing profits from private equity investments—selling company equity through IPO or transferring it to other private equity funds or buyers—have significantly slowed down in recent years.

Although investors are able to receive their returns, the practice of private equity initiators using leverage to pay dividends to the company, known as "dividend reinvestment" ( dividend recapitalizations ), may also weaken the company's investment capacity or its ability to withstand future downturns in the market.

Moody's rating indicates that since 2022, the activity of " dividend recap " has increased significantly. As company sales have declined and IPO remains sluggish, the agency expects this activity to continue to remain high in Europe, the Middle East, and Africa, as private equity firms are looking for ways to return funds to investors.

The rating agency estimates that private equity holding companies in Europe, the Middle East, and Africa can still increase their debt by another 41 billion euros (46 billion US dollars) before reaching the level of leverage that typically triggers a downgrade in their ratings.

There are still "very few" exit channels.

Moody's latest analysis shows that this approach is still mainly limited to the companies with the strongest performance and the greatest ability to bear additional debt. This means that this "significant additional leverage capacity" may support a further increase in dividend recapitalization.

However, this does not solve the problem of backlogs in exits that weigh down the private equity industry. Nowadays, funds hold onto companies for far longer than the usual five to six years.

Moody's analyst Mayank Mallik stated: "The fundamental issue is that there are very few exit opportunities – European IPO markets have been weak, and after the last round of interest rate hikes, the capital available for strategic acquisitions by large corporations has become much more expensive. Overall, we are more concerned about the impact of the entire private equity ecosystem on corporate credit quality – and this is one of the key transmission mechanisms at play currently."

Moody's stated that private equity sponsors have always been 'prudent' in selecting targets for dividend recapitalization, with the services sector, consumer goods, and manufacturing being the most active.

Mallik points out that most dividend reinvestments occur in companies that perform better than their original business plans. New debt typically restores the leverage ratio to its initial level without having a 'substantial' impact on exit opportunities.

He told CNBC via email: “However, there is one thing to note: companies preparing for IPO usually hope to demonstrate a stable deleveraging record for several consecutive years before entering the market.”

"If the IPO window opens unexpectedly, issuers who have recently conducted div recap may miss the opportunity, and there is indeed a risk in that. Any company undertaking div recap is most likely making a forward-looking judgment, believing that the IPO market will not open in the short term."

Moody's, citing PitchBook data, states that the amount allocated to investors has declined significantly in recent years. The allocation from private equity has dropped from over 30% of the initial net asset value in 2022 to about 12% at present.

Mallik added, "If the backlog of private equity exits persists for too long, the initiators may begin to consider liquidating relatively weaker credit assets, which could lead to a deterioration in the credit quality of the entire investment portfolio."

He stated that these risks are greater than they were ten years ago, partly because the terms of relevant documents are now “quite lenient” for issuers seeking to take on additional debt.

Tense credit markets temporarily support refinancing.

The recapitalization of portfolio companies is typically financed through the extensive syndicated loan market, with multiple investment banks lending together to the borrower in order to diversify risks. Another method is to raise funds through the issuance of high-yield corporate bonds or private credit loans.

Raymond James' Global Private Capital Consulting Director Sunaina Sinha Haldea stated that there is still "considerable financing capacity" to support such recapitalizations at present, and the tight interest rate spreads as well as the scarce supply of new loans are helping to maintain market demand.

She said, "If profits weaken, the interest rate spread widens, or investors withdraw their funds, availability may tighten; whereas a recovery in acquisition financing will provide lenders with more alternative options, rather than having to fund dividend payments to shareholders."

Haldea points out that the recapitalization of dividends can provide liquidity and alleviate selling pressure, but it cannot ultimately resolve the valuation gap.

She told CNBC via email: “Investors will be able to get some cash back, but the assets will still remain in the fund, and ultimately, a buyer still needs to be found.”

"If profit growth truly creates a real ability to borrow, then reinvesting dividends may not necessarily undermine the ability to exit the market; however, if borrowing is done based on expectations of future growth, that's another matter. More debt means less financial flexibility, and with the same corporate value, shareholders will end up with less equity value when the company is eventually sold."