For a handful of private equity-backed specialty retailers, the holiday season stuffed coal in their stockings and fears of default in their hearts. A tough Christmas season pummeled Apollo Management LP-backed Claire's Stores Inc., as well as Loehmann's Holdings Inc., owned by Istithmar World PJSC, the private equity arm of Dubai's sovereign wealth fund. Bain Capital LLC's Guitar Center Inc. is also under pressure, while luxury retailers generally were badly shaken.

Specialty retailers are "heavily reliant on a good holiday season," says Maggie Taylor, an analyst with Moody's Investors Service.

Claire's, which Apollo purchased in a $3.1 billion leveraged buyout in May 2007, is evidently relying on its recently tapped revolver to cover its interest expense. The company's free cash burn has long been a problem, which its heavy interest burden made worse, Taylor says. "There's no relief in sight."

Early signs indicate that retail had a difficult holiday season. Same-store sales are down despite steep discounts of up to 70%, and still the stores are empty, says Steven Tricarico, a managing director of Jefferies & Co. Mall traffic has been down all year, says Taylor, but Claire's, which sells "value-priced" jewelry and accessories for girls and young women, might be helped by the fact that "it has very low price points." It sells earrings for less than $10.

Discount retailers tend to be more resistant in a downturn, as evidenced by Dollar General Corp., owned by Kohlberg Kravis & Roberts & Co. KKR, Goldman Sachs Capital Partners and Citigroup Private Equity acquired Dollar in a $7.3 billion leveraged buyout in July 2007. After a disappointing holiday season that year, the discount chain emerged as a bright spot among highly levered retailers. And it has since continued its upbeat performance.

On Dec. 15, Standard & Poor's Ratings Services shifted the outlook for Dollar to positive from stable after it posted "better-than-expected operating results for the third quarter ended Oct. 31." It affirmed its B corporate credit rating. The Goodlettsville, Tenn., company's third-quarter sales climbed 12.4%, to $2.6 billion, with same-store sales rising 10.6%. Its adjusted Ebitda soared 61%, to $228.6 million, from $86.5 million for the same period in 2007.

At the end of the third quarter, it carried $4.18 billion of debt, or 4.7 times its adjusted Ebitda, implying that it would generate around $889 million annually. Its leverage multiple has declined considerably from about 7 times just after the buyout.

And unlike Claire's, the company has not drawn down its revolver.

The bond market reflects its positive performance. As recently as Jan. 6, the company's senior unsecured bonds were trading at 97.5 cents on the dollar, according to Thomson Reuters. Highly distressed Claire's, by contrast, was trading at around 20 cents on the dollar the week after Christmas.

One banker argues that, while struggling, Claire's is not in imminent danger of a bankruptcy filing. He says it has no financial covenants, unlike many big LBOs struck in the good times between 2004 and early 2007. Given this -- and the cash it's sitting on, thanks to its revolver -- its capital structure "could buy more time" than people tend to think. Also, Apollo could help restructure its balance sheet by buying back Claire's debt for 30 or 40 cents on the dollar or pump additional equity into it.

Last year, Apollo's equity investment in Linens 'n Things Inc. was wiped out after it failed to turn itself around amid tough financial markets and a pullback in consumer spending. It had bought the home furnishings chain for $1.3 billion in February 2006, and in May 2008 it fell into bankruptcy. But Linens was clearly in worse shape than Claire's, the banker says, with a broken business model and deteriorating relationships with major vendors.

Still, Claire's could have a lot riding on a successful Christmas season, given its debt burden. In the first nine months of 2008, the retailer didn't generate enough Ebitda to cover its nearly $148 million of interest expense.

Claire's has already pulled a couple of levers. In May, it elected the pay-interest-in-kind feature of its senior toggle notes, deferring cash payments from June 1 through Nov. 30. Pay-in-kind notes allow a company to pay interest with more debt than cash, giving it some breathing room. Moreover, in order to build a liquidity cushion, it has drawn down the remaining $194 million available under its revolver.

In its third-quarter results, released in early December, Claire's revealed the difficulties it has encountered due to its highly leveraged position. In the first nine months of 2008, net sales fell 4.1%, to $1.02 billion, while same-store sales experienced a steeper decline of 6.8%. Adjusted Ebitda dropped 26%, to $137 million, from the $185.5 million generated in the same period of 2007.

As a result, Moody's downgraded the company's long-term credit ratings, including its probability of default, to Caa3, from Caa1.

Bronx, N.Y., discount women's apparel retailer Loehmann's is also "on the brink" of default, Moody's analyst Maggie Taylor says. Moody's has given it a Caa2 rating. Loehmann's says it sells, upscale, name-brand designer fashions for 30% to 65% less than department stores, according to its Web site. Moody's pegs its revenue at around $490 million.

Istithmar bought the discount retailer from buyout firm Arcapita Inc. in a secondary buyout for $300 million in 2006. At the time, valuations in specialty retail were at an all-time high, giving Arcapita a lucrative exit less than two years after buying it for $178 million.

Times have clearly changed. The company is now generating negative Ebit and negative free cash flow, according to Moody's. Unlike Claire's, however, Loehmann's has a $55 million letter of credit from its sponsor, Istithmar, which expires in March.

The slowdown in consumer spending has caused a paradigm shift in retail, says Jefferies' Tricarico. Equity investors are no longer focusing on growth, he says, but on a company's cash position, strength of its capital structure and deleveraging.

Meanwhile, Guitar Center, which Bain Capital bought for $2.2 billion in October 2007, looks to be in a better position to weather the recession, thanks partly to its strong market position in sales and rentals of musical instruments. On Sept. 16, Moody's cut Guitar Center's rating to Caa1, predicting the company's free cash flow over the next year "will likely be modestly positive to breakeven level." Moreover, its term loan contains a single financial covenant -- a senior secured leverage ratio for which the company is expected to have ample cushion. Guitar Center has also benefited from deferring cash payments on its PIK notes.

The usually recession-resistant luxury retail niche took a big hit over the past year. "The bottom has fallen out," says Tricarico, as even people who "have the money" are spending less. On Dec. 15, Moody's downgraded sponsor-backed Nieman Marcus Group Inc.'s unsecured debt to B3, from B2, due to weaker operating performance. It also changed the luxury retailer's outlook to negative. TPG Capital and Warburg Pincus bought Neiman Marcus for $5 billion in cash in 2005.