Capital Markets

Debt Picture Clouds Private Equity

Credit quality has plummeted, and especially so recently, for many companies where LBOs were transacted since 2004, Fitch finds.
Vincent Ryan and Stephen TaubJune 13, 2008

U.S. companies that were taken private through a leveraged buyout over the last four years are particularly at risk of eroding credit quality default, according to a new study by Fitch Ratings.

An analysis of 209 loan-financed LBO transactions executed between 2004 and 2007 found that from completion of a deal through May 2008, the ratio of credit-rating rating downgrades to upgrades was 3.3 to-1, and the average downgrade was 2.3 notches.

More than a fourth of the downgrade actions and three of the four recorded defaults occurred during the first five months of 2008, underscoring the toll current economic and credit market conditions are taking on these credits, according to Fitch, which analyzed about $293 billion in leveraged loan debt.

The debt rating agency said weak operating performance and an inability to generate sufficient cash flows to service post-LBO debt loads were the primary drivers behind about 80 percent of the downgrades.

The next-most-common factor was additional post-LBO debt issuance used to fund a dividend payment to equity sponsors, accounting for 15 percent of the downgrades.

“The greater risk tolerance that existed in years past enabled many of these deals to come to market with very aggressive capital structures,” said William May, senior director of Fitch Ratings Credit Market Research. “Now that economic conditions are weak and liquidity is tight, these credits are being tested.”

A recent study of the credit performance of leveraged buyouts by noted fixed income analyst Martin Fridson echoes Fitch’s findings. Bond and loan issues from LBO deals executed since 2002 are disproportionately distressed, Fridson said at a New York Society of Security Analysts conference this week. (Distressed debt is that trading at an interest rate of 1,000 basis points or more over Treasuries, an indicator of possible default.)

In a representative sample of LBO debt Fridson studied, 26.6% of issuances were trading at distressed levels as of January, versus 18.6% for the bonds in Merrill Lynch’s High Yield Master II Index. Debt from private-equity deals transacted in 2007 and 2008 had the highest incidence of distress among years studied, at 67.6 percent and 75 percent, respectively.

Analyzing the 15 largest private-equity firms, Fridson also found that distressed debt from individual-sponsor deals was as high as 42 percent, with almost half the firms having more than 30 percent of debt issues in distress.

The future doesn’t look too good either for LBO-related credits. According to Fitch, 44 percent of the LBOs examined had a negative rating outlook as of May, versus just 3 percent with a positive outlook.

Fitch’s analysis also found that 23 percent of LBO credits examined consisted of firms in consumer cyclical industries, and a further 15 percent were in the broad industrial category. This is evidence that a meaningful share of the LBOs brought to market in recent years are particularly sensitive to the overall economic weakness and consumer retrenchment currently plaguing the U.S. economy.

Indeed, consumer cyclicals and industrials lead the way in pointing to downward pressure on credit quality going forward, Fitch added. Through May, consumer cyclicals, which accounted for roughly one-quarter of LBOs examined, recorded 36 percent of the LBO downgrades and two of the four defaults.