Private equity or bust

As defaults continue to rise, the owner of the entity in default is more likely to be a private equity firm, according to Standard & Poor’s. The finding should give pause to investors who invest alongside private equity firms, said S&P managing director Diane Vazza.

In the first eight months of 2008, 55 entities defaulted globally, compared with just 22 in 2007. Of the 55 defaults, nearly 70% were involved in private equity transactions at one point or another.

Among the latest crop of failed private equity investments included in the latest study were: Tousa, Buffets Holdings, Plastech Engineered Products, and Linens ‘n Things, all of which filed for bankruptcy protection.

Bankrupt retailer Mervyn’s also fits the profile. Mervyn’s is suing its former private equity owners, claiming that the private equity funds improperly stripped the company of its real estate assets.

Vazza said the private equity model of buying low and selling high inherently led managers to seek out dysfunctional, underperforming or distressed entities that they could fix or, in the event of a default, recoup their investment.

These investors typically sought above-average returns by taking on exposure to higher-risk credits, particularly to entities at the lower end of the ratings spectrum where there was less room to manoeuvre, Vazza said.

The likely result of seeking out dysfunctional companies is that a good portion of those investments will go bust, especially in a less forgiving environment. But given that 70% of the current defaults are tied to private equity, some sponsors may have understated their default risk exposure, she said.

While there will be more private equity fingerprints on the majority of the corporate defaults over the next 12 to 18 months, Vazza said strategies and financing adopted by private equity sponsors were not always to the detriment of ailing companies. Some might have already deferred or even averted defaults.

The default rate increased for eight consecutive months to 2.5% in August. The rate is expected to reach 4.9% during the next 12 months. While the US accounted for 53 of the 55 defaults globally, defaults are expected to spike in Europe. So far, however, exposure to Spanish real estate or a reliance on aviation fuel are greater indicators of weakness than sponsor backing.

For private-equity backed deals, the gaming sector has been especially hard hit, but sponsors have so far been supportive, a comfort for banks given the loose hold lenders have on recent LBO structures.

In April sponsors Candover, Cinven and Permira completed an equity cure totalling £125m for Gala Coral, in return for a debt amendment package.

The cash injection came after an agreement with creditors, who had been concerned the group could breach covenant limits over the next few years. The deal saw £82m of senior debt paid off and £42m placed on the balance sheet for additional covenant headroom.

In August Waterland Private Equity Investments bought up the distressed senior debt backing its buyout of JVH Gaming, a Netherlands-based slot-machine operator. The move means it regains ownership of the business after seeing its original equity stake wiped out.

The private equity owner had lost control of JVH when profitability was halved in the wake of a new Dutch tax regime for slot machines. While equity investors and lenders were initially left reeling, the resolution of the situation again hints at a generally supportive attitude from sponsors, even where they have seen equity eroded.