Capital Markets

Most Firms Near Default Have Private Equity Ties

S&P report says these U.S. "weakest links" have increased sharply since mid-2007.
Stephen TaubMarch 19, 2008

A majority of the companies deemed to be closest to the default threshold were recently involved in private equity transactions, according to a new report from Standard & Poor’s.

The debt rating company reported that the number of such “weakest links” has increased significantly since mid-2007. As of March 10, there are 114 weakest links, of which 93 are U.S.-based. This compares with 77 in December and 62 in June 2007.

In its finding about the private equity connection, S&P said, more than half those 93 U.S. corporate weaklings were involved in PE transactions. “This is not surprising,” the report explained, “as a deluge of liquidity in the bond and loan markets in recent years has spurred a wave of leveraged activity, including private-equity sponsors seeking to put cheap money to work on behalf of their clients.”

Weakest links — which S&P described as companies closest to default — are defined as entities rated B-minus and lower with either a negative outlook or with ratings on CreditWatch with negative implications.

What’s more, S&P pointed out, the proportion of sponsor involvement increases at lower rating categories, suggesting that private equity firms “in their acquisitive phase” may have built up a disproportionate exposure to companies carrying the greatest risk of default.

For example, private equity presence exceeds 60 percent among entities rated CCC-plus or lower, but 40 percent among entities rated B-minus.

Keep in mind that S&P has found that over the years, on average, 43 percent of entities rated CCC-plus or lower default within three years, versus just 28 percent for B-minus rated companies.

“The default risk exposure may be magnified this time around, because current market conditions have constrained the typical exit options afforded to sponsors,” such as an initial public offering, S&P noted.. However, long-term investors may yet be well positioned to ride out the ongoing volatility, the rating company adds.

In fact, of the 11 U.S. defaulters recorded in the year to date, five entities were associated with ties to private equity.

Historically, bad timing for leveraged buyouts can be deadly. This is because companies targeted by an LBO, “often led by a private-equity sponsor,” count on issuing additional debt or growing into their debt load to make the venture worthwhile for their investors. If these conditions are missing, the absence of a financial cushion may cause considerable damage for the target companies, S&P said.

The report also pointed out that for the past nine months, the sectors most vulnerable to default have been media and entertainment, consumer products, and retail/restaurants.