LBOs Face Mounting Credit Risks, S&P Says

With debt burdens approaching the levels of the last LBO boom, the ratings agency warns there could be trouble for issuers.
Katie Kuehner-HebertNovember 4, 2015

Standard & Poor’s has issued a warning about the leveraged buyout market, saying credit risks are rising as private equity firms lever up deals to levels not seen since the boom of 2005 to 07.

The LBO market has been relatively sluggish over the past couple of years amid increased regulation and rising equity valuations, especially when compared to the robust market for strategic mergers and acquisitions.

With fewer potential deals, S&P said in a report released Wednesday, private equity sponsors are pushing increasing amounts of leverage on new LBOs.

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“As the 2005-2007 LBOs have shown, excessive leverage increases credit risk and could spell trouble for recent LBO issuers if capital market and economic conditions deteriorate,” the report warns.

S&P also noted that regulatory pressures to curb the amount of debt used to finance LBOs may have the unintended consequence of increasing credit risk on new take-private transactions. Moreover, financial sponsors are sitting on a near-record $540 billion of cash, and will need to put this money to work over the next couple of years.

“This abundance of capital could signal a pickup in LBO activity and weaker credit metrics for some corporate issuers over the next few years,” the S&P analysts wrote.

According to The Financial Times, the debt burden of the largest 20 companies taken private since the start of 2014 has climbed to an average 7.6 times unadjusted earnings, about a point below the 8.7 times average recorded for the biggest transactions in the 2005-07 boom.

Some recent LBOs have exceeded the six-times leverage ratio guideline set by regulators in 2013, which defines a deal as risky.

“With $539.4 billion in dry powder sitting on the sidelines … the concern is PE managers will overpay for assets that will fail to grow into [a] new, often highly levered, capital structure,” the FT said.