Hold Your Breath For The Tsunami of Defaults Due To Hit in Q1

Not to fear monger, but here’s some scary math: Special situation pros are predicting default rates will eventually hit between 5% and 8%. That’s pretty high, considering that right now the 12-month trailing default rate for speculative grade debt is 2.68 percent. Year to date, 60 of the 2,238 US companies tracked by S&P are in default. Out of those 60, 22 are backed by private equity firms. That means more than a third of all companies in default are, depending how you frame it, “victims” of leveraged buyouts.

If the default rate does indeed rise to even 5% by year-end, and the LBO ratio remains stable, then it could mean 111 more buyout-backed company defaults. Note that the number of buyout-backed defaults (22) is much lower than the number of Chapter 11s (39).

The only saving grace is that most people I speak with believe the real bloodbath will hold off until the first quarter of next year. By that time, the highly-leveraged, covenant-lite, ‘06-‘07 mega-buyouts will have had enough time to ripen, decay and rot.

Thus far, the ’08 buyout-backed defaults have deal values below $5 billion. Do turnaround experts expect a mega-buyout bankruptcy in Q1? “Certainly,” said Mo Meghji of Loughlin Meghji + Co., a restructuring advisory firm. Not only are the big LBOs finally coming of age, they have dangerously loose covenants. Beyond that, Meghji said, for the past year or so, sponsors and companies have been drawing down their revolvers as a way to stem the tide. This is a trend not seen in prior downturns. That liquidity option will dry up soon enough, too.

Lorie Beers of KPMG’s Special Situations agreed that people seem to be holding their breaths for a giant wave of defaults in Q1 of next year. “The 12 to 18 months after that will be a very bumpy ride.”