Private Equity-Owned Companies Facing Tougher Times
Highly leveraged private-equity backed companies are facing a more difficult operating and credit environment, increasing the risk of downgrades, according to Moody’s Investors Service
In a new report, Moody’s analyzes the credit risks associated with private-equity owned companies. The report, Private Equity: Tracking the Largest Sponsors, is worth reading just for Moody’s breakdown of private equity deals since 2002, which lists 220 companies and their associated buyout firms.
Equally useful is a table ranking the firms by number of deals, value, ratings changes, dividends, acquistions, and sale or IPOs within 3 years. The Carlyle Group tops the list with 41 deals, though Kolberg Kravis Roberts had the highest total value at $165.7 billion.
Moody’s found significant differences in financial strategy among the firms analyzed that can be particularly important for debtholders. “By tracking a given private-equity firm’s propensity for large dividends or acquisitions, for example, investors will be in a better position to gauge the potential for ratings changes.”
Thomes H Lee and Bain each had 10 deals downgraded, the largest absolute number of downgrades, representing 63% and 40% of their deals, respectively, the report shows. Apollo, Blackstone and Warburg Pincus also had roughly 40% of their deals downgraded. JPMorgan had 46% of its deals downgraded. Only one Kolberg Kravis Roberts-sponsored deal and one Cerberus-sponsored deal was downgraded and KKR was the only firm to have more upgrades than downgrades.
When it comes to post-deal strategies, some firms were much more aggressive in extracting dividends from their companies.
“Six firms were particularly aggressive, taking dividends in 50% or more of the deals: Welsh Carson, Cerberus, Providence Equity Partners, Carlyle, Madison Dearborn and TH Lee. Other firms, like KKR, Goldman Sachs and Bain, took dividends in only one-third of their deals. In 50 deals, dividends erased 80% or more of the cash equity used to finance the initial transaction.”
Of the companies in Moody’s study, only two, or 1.1%, defaulted between 2002 and 2007, compared with a 3.4% high-yield default rate over the same period.1 Despite this low default rate, Moody’s “recognizes that these companies are highly leveraged and their increasing numbers correlate with the rise in the number of companies in the “B2” or “B3” corporate family rating (CFR) categories.”
Given their elevated leverage, these companies could come under much greater financial stress over the next several years in a more restrictive credit environment.
Hence, Moody’s expects the default rate for these companies to increase along with all other companies rated in the “B” category.
What’s unknown is whether these large private-equity firms will use their capital to provide additional funding for their distressed companies to prevent them from defaulting. We should note that seven companies owned by these large private-equity firms currently have a CFR of “Caa1” or lower. Hence, the risk of default could increase significantly over the next 12 to 24 months, unless the sponsors provide support.
The Financial Times reports that Moody’s will adopt a tougher stance when rating companies owned by private equity firms that have been more “aggressive.” The FT quotes Moody’s senior vice president John Rogers as saying “the interesting aspect is finding out which firms support their companies and which firms don’t.”
At the start of the next up cycle, we will be much more cautious in how we rate these firms.
“We expect the tighter credit environment will limit the financial flexibility of companies that underperform relative to current expectations,” says Rogers.
In a November 2007 report, Credit Implications of Corporate Governance in Private-Equity Owned Companies, Moody’s said its “governance analysis varies as the private equity firm acquires, runs and sells the company. “
The report notes that private equity owners have a high tolerance for leverage/risk and minimal public transparency.
“This approach heightens credit risk and highlights that private equity owners pay less regard to bondholders (at least, holders of bonds prior to the buy-out). The owner’s relatively short-term investment horizon creates event risk.”
However, Moody’s adds that private equity ownership can bring some governance strengths, such as: active boards comprised of directors with significant experience; strong performance management; and an ongoing commitment to robust controls and financial reporting processes.
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