A new Moody’s default report reveals a troubling paradox: Private equity-sponsored companies are more likely to default, yet they’re also more likely to recover from default. It’s a leveraged catch-22.
The argument is that because of private equity’s appetite for leverage and dividends, their portfolio companies are generally at higher risk. No surprise there. Most PE-backed companies receive a B1 corporate family rating after their LBO — indicating high leverage tolerance and relatively low default rates — but a number of LBO-backed companies didn’t maintain that B1 rating very deep into the recession. Moody’s data blames half of all corporate defaults in 2009 on private equity.
But the report counters that creditors of private equity-backed companies may realize better recoveries than those that lend to strategically owned companies. The idea is that private equity firms are so focused on preserving their equity that they’re more willing to get creative when a portfolio company gets in trouble. That means distressed exchanges and pre-pack bankruptcies.
Of the 77 private equity-backed defaults tracked by Moody’s, 44.2% resulted in a distressed debt exchange and 15.6% ended in a pre-pack bankruptcy. Compare that to strategic defaults, which favored Chapter 11 bankruptcy and missed interest payments as outcomes, with a respective 36% and 8.1% for strategic defaults.
Moody’s argues that pre-pack bankruptcies are better for creditors because of lower costs, less uncertainty than a prolonged bankruptcy period, and little or no effect on trade creditors, customers and employees. Distressed exchanges are similar—PE-backed companies can undergo these transactions much more efficiently because their investor base is concentrated and they bring strong relationships, access to capital and financial sophistication to the table.
So I suppose that supports the argument that investing in low-grade debt of LBO-backed companies less risky than, say, that of a publicly traded company.
But it’s not that simple. LBOs from the top of the boom cycle are more vulnerable to default, and the mega-deals, well they just look like crap. Four of the ten largest LBOs have already defaulted with three distressed exchanges and one bankruptcy, and two are considered distressed. The lone shining Beacon of success, of course, is HCA, which Bain and KKR hustled into a dividend payment earlier this year when an IPO looked less likely for the near term.
Moody’s concludes that increased dividends and the continued resurgence of high yeild issuance in 2010 to will lead to what is essentially a return to the covenant-lite days. The best way for creditors to overcome that is equity cushions and something Moody’s calls “covenants with teeth.” I imagine those look something like the metal cilice worn by that creepy Opus Dei character in The Da Vinci code. In reality the “teeth” include limitations on distributions and financial maintenance metrics.
Further, there may be a rise in PE-backed defaults, despite the slowdown we saw over the last six months. The recent slowdown, aided by amend and extend and covenant lite, may be artificially helping companies with liquidity problems but failing to address their fundamental weaknesses. Furthermore, that strong recovery figure may drop off, thanks to a lack of liquidity in the marketplace and a record number of defaults in 2009.
In other words, it’s not over yet.