Even as an ambitious government bailout attempts to shift much of the risk away from financial institutions that are deleveraging, it isn't clear how debt-addled portfolio companies of private equity firms might weather a further tightening of credit. When banks and other lenders are looking to purge distressed assets, troubled borrowers could get into deeper trouble still.

Private equity's fingerprints are evident on many of this year's defaults. Of the 55 businesses that defaulted globally in the first eight months of 2008, nearly 70% were involved in transactions with sponsors at one point or another, according to a Standard & Poor's report in September. "Some sponsors may have understated their default risk exposure," given robust market conditions at the time, the report said. (The 55 include some companies controlled by vultures that bought in after the company got in trouble.)

Recent ratings downgrades for Michaels Stores Inc. and Guitar Center Holdings Inc., both LBO'd by Bain Capital LLC at the peak of the market, underscore just how current economic conditions have overturned previous assumptions, particularly in vulnerable sectors like retail.

Some companies like Irving, Texas-based Michaels that have covenant-lite debt have more breathing room than they would with traditional covenants. When Bain and Blackstone Group LP acquired the arts and crafts retailer chain for $6 billion in June 2006, they won very flexible debt terms, arguing that the chain was a category killer. At the time, the company claimed strong free cash flow projections without huge capital expenditures, and it took on $3.75 billion of long-term debt.

In the six months ended Aug. 2, the top line has declined, with same-store sales down 2.8%, according to the company's latest filing this month. Operating margins fell, and Moody's Investors Service said those sales are unlikely "to materially recover to historical levels in the near term." This prompted a ratings downgrade from B2 to B3.

Guitar Center also had a dominant competitive position when Bain bought it less than a year ago for $2.2 billion. On Sept. 16, Moody's cut its corporate rating to Caa1. While sales are still increasing, growth is likely to remain sluggish for the foreseeable future, Moody's said, leaving the company more highly leveraged than the agency had projected. Though the company does not disclose results, Moody's made it clear that Guitar Center is performing marginally, predicting that free cash flow over the next year "will likely be modestly positive to breakeven level." Guitar Center does not have covenant-lite debt but a $375 million asset-backed revolving line of credit that provides a cushion against default.

Other companies have also been downgraded in recent weeks, including Hawaiian Telcom Communications Inc. (owned by Carlyle Group); Perkins & Marie Callender's Inc. (Castle Harlan Inc.); and Univision Communications Inc. (Providence Equity Partners Inc., TPG Capital and Thomas H. Lee Partners LP).

Also on Sept. 16, Mississauga, Ontario-based Masonite International Corp., a Kohlberg Kravis Roberts & Co.-backed residential and commercial doormaker, said it reached a forbearance agreement with lenders allowing it to work out its credit terms after breaking its financial covenants in June. There's no assurance that the agreement will succeed, but it expires Nov. 13.

KKR invested $552 million of equity when it acquired the company in April 2005 for $2.7 billion. Whether KKR ponies up more equity at this point remains to be seen. Masonite has drawn down its entire revolver as of the second quarter and has only $241 million of cash available as of June 30. "I do believe Masonite will need additional capital," says Michael Henkin, managing director at Jefferies & Co.

Moody's baseline forecast has the global speculative default rate rising to 4.9% by the end of 2008, from 2.7% as of Aug. 31. But its downside scenario could raise it to 12% to 13% in the next 12 months. That rate is above the 2001 level, which reached 11%, but comparable to the 1990-'91 level of 12%.

Covenant-lite mechanisms may in fact be helping to suppress the default rate, which should otherwise have shown a steeper spike, says Kenneth Emery, director of corporate default research at Moody's. The latest financial turmoil certainly doesn't bode well for distressed issuers that need to get refinancing, says Emery. For those distressed issuers unable to get refinancing, he adds, "their only likely avenue would be bankruptcy."

-- John E. Morris contributed to this article.