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If It’s Pizza You’re Offering, MidOcean’s Had Enough

Pizza chain Sbarro’s Inc.‘s woes continue to plague MidOcean Partners and its troubled Fund III.

The pizza chain recently missed an interest payment and, since MidOcean bought it in 2007, it has struggled with its debt load amid cautious consumer spending and heightened commodity prices. Bad luck has hit its international expansion plans too. In 2010, it announced plans to open 1,250 restaurants throughout…you guessed it, Japan, which is now reeling from the recent earthquake and tsunami catastrophe. (The company also has plans to open locations in Brazil.)

Moody’s Investor’s Service, the ratings agency, on March 11 revised the Melville, N.Y.-based company’s probability of default rating to Ca/LD from Ca. The rating action, which Moody’s bestows on companies in default on a limited set of debt obligations, follows Sbarro’s failure to make a February interest payment on its 10.375 percent notes due 2015, the grace period for which ended on March 3. Sbarro’s also announced that it has entered into a third forbearance agreement with lenders under its first-lien credit statement.

In perhaps its most dire assessment yet of Sbarro’s, Moody’s said its ratings outlook is negative, reflecting “the uncertainty with regards to Sbarro’s ability to remain a going concern.”

Sbarro’s, which according to Moody’s generates about $333 million in annual revenues, hasn’t been the only problem for MidOcean Partners III, a $1.25 billion fund closed in late 2007. As of June 30, 2010, the fund had generated a 0.50x investment multiple and a -30 percent internal rate of return, according to the California Public Employees’ Retirement System (CalPERS is not a direct investor in the fund, but keeps data from Sacramento Private Equity Partners, a fund family managed by Oak Hill Investment Management).

Sbarro’s sells pizza and other Italian food through 476 company-owned restaurants and 538 franchised restaurants. MidOcean bought the company at perhaps the worst possible time. In January 2007, about the peak of the then-booming economy, the firm paid approximately $450 million, with at least $208 million in debt financing led by Credit Suisse Securities and Bank of America Securities.

Only a few months later the credit markets chilled and the Great Recession took hold. Cautious consumer spending and rising prices for flour and cheese—two critical ingredients for pizza—spiked in 2008, making it more expensive for Sbarro’s to do business. The cost of cheese in the first nine months of 2008 increased nearly 20 percent to an average of about $2.18 per pound compared to an average of about $1.82 per pound in 2007, as Buyouts previously reported.

Meanwhile, MidOcean is trying to stabilize some other struggling Fund III deals. Last year Penton Media Inc., the print and online publisher of National Hog Farmer, Modern Baking, and other B-2-B titles, went through a pre-packaged Chapter 11 process. And U.K. fitness chain LA Fitness was operating at a loss as of May 2010, when the company launched a three-year turnaround plan.

In November 2009 MidOcean, which does not specialize in turnarounds, hired turnaround specialist Steve Miller, who reportedly helped revive businesses such as Delphi Corp., Bethlehem Steel and Federal-Mogul Corp., not as an operating partner, but as its chairman.

MidOcean executives declined to comment.