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— Private Equity —
Private equity was very much in evidence among the fallen last year. Standard & Poor's Capital IQ data tracker tallied 218 Chapter 11 filings in the U.S. by companies with private equity and venture capital funding, compared with 117 in 2007. That's an 86% increase. Forty-eight private equity-backed companies filed in the U.S. alone, according to The Deal research. None of this should come as a shock. Edward Altman, the financial world's prophet of doom, had warned as early as 2002 that defaults will rise sharply in two to four years after issuance, citing the surge in low-rated junk bond issuances at the time. Unfortunately for the New York University Stern School of Business finance professor, the financial markets stayed improbably liquid, rendering his predictions off course by a few years. But it wasn't that hard to come to the same conclusion, considering the unprecedented levels of junk bond issuance and leveraged loans in the past five years. For over two decades, the most common rating for U.S. corporates, especially industrials, was B+, well into speculative grade to begin with.
In the last five years, however, there was a preponderance of B ratings. This has edged downward further in recent quarters, with a spurt in B-, below which companies are really in trouble. The shift was more perceptible during the buyout boom years. In 2003, 57.5% of S&P's U.S. industrials debt ratings were rated B+ (excluding utilities and financial institutions). By 2008, B+ had dropped to 33.8%, and B ratings had jumped to 46.3% in 2007, from 29.3% in 2003. Meanwhile, B- ratings climbed to 22.8% of industrials last year, from 13.2% in 2003. Looked at another way, only 7% of S&P's total rating distribution were B ratings in 2003, but this leaped to 44% by 2008. "You started seeing companies going for debt-to-Ebitda multiples of 7 times, 9 or 10 times at the start, and that's pretty unforgiving if things go bad," says Nicholas Riccio, managing director at S&P. "The problem is that people started thinking things will always be good. It just doesn't always work that way." Last year's bankruptcies were attributed primarily to the combination of deepening economic woes and the heavy debt burden companies had shouldered going into the recession. In most cases, the financial sponsors' money would have been decimated in Chapter 11 restructuring, had it not already been written off. Many of the transactions were private, making a precise count of cumulative equity losses difficult. With cheap financing easily obtainable at the time, investors could have raked returns through dividend recapitalizations, which were plentiful during the boom years. There were embarrassingly large busts, for sure. These include Apollo Management LP's $633 million bet on retailer Linens 'N Things Inc. and Willis Stein & Partners LLC's $550 million investment in New York publisher Ziff Davis Media Inc. But many of the casualties were small to midsize businesses with bad balance sheets and-or operating problems. A downturn is inherently more dangerous for midmarket companies than larger ones because they generally lack the size, scale and flexibility of larger companies to avoid defaulting on payments. A few were repeat offenders, and several involved investments made long ago. Take Clayton, Dubilier & Rice Inc. portfolio company Sirva Inc., a provider of moving services. The company had struggled since the New York buyout firm acquired it for $350 million a decade ago. CD&R took Sirva public in 2003, only to see it flounder on accounting mistakes and mismanagement. Even pedigreed private equity firms with turnaround credentials have not been immune. That's the risk buyout shops take when they come to succor ailing companies. Figuring prominently is Boca Raton, Fla., buyout shop Sun Capital Partners Inc., which grabbed the top slot with six failed bets -- Wickes Holdings LLC, Lillian Vernon Corp., Powermate Corp., Jevic Holding Corp., Mervyn's Holdings LLC and publicly traded Sharper Image Corp., in which a Sun affiliate was among the largest shareholders at the time of the filing. Runners-up include: Thomas H. Lee Partners LP, Cerberus Capital Management LP, Madison Dearborn Partners LLC, Catterton Partners, Golden Gate Capital and Hancock Park Associates. Each of these had two. Catterton had the bad luck of seeing two portfolio companies -- two units of Archway & Mother's Cookie Co. and Sleep Innovations Inc. -- go belly-up within three days. Will this downturn yield a bumper crop of private equity-backed bankruptcies as many anticipate? Time will tell. The PE-backed bankruptcies to date barely dent the mountain of capital poured into leveraged buyouts -- more than $90 billion in 2007 alone. Clearly the worst is yet to come, as the deepening recession and frozen credit markets leave few companies unscathed in the post-covenant lite era. Defaults have accelerated in recent weeks. "Companies that are highly levered are facing higher borrowing costs, and weaker cash flows just make it that much more challenging," says John Puchalla, an analyst at Moody's Investors Service, which downgraded 34 companies in the fourth quarter to its lowest speculative-grade liquidity rating. That's triple the third-quarter total. Already, four PE-backed companies have filed in the first few weeks of January . The recent wave of distressed debt exchange offers by struggling companies -- Realogy Corp., Harrah's Entertainment Inc., GMAC LLC, Neff Corp. -- amounted to defaults by another name, according to experts. "Even though there's no payment default, we consider these as selected defaults," Riccio says, where debt trading at, say, 60 cents to the dollar is exchanged for new debt at 50 cents to the dollar, with new maturities. "On a tactical level, a debt exchange does make sense if you can get rid of a certain amount of debt by just issuing new debt or exchanging it with new debt, because you're improving your posture financially," Riccio argues. The problem is, he adds, the maneuvers may not be enough to keep companies away from bankruptcy courts.
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