Not all that fail proof

A year ago, Aleris International Inc. CFO Sean Stack confidently predicted in an earnings call that Aleris' covenant-lite credit package would immunize the aluminum products producer from default. Aleris, which TPG Capital acquired in a $3.3 billion leveraged buyout in 2006, was one of numerous companies LBO'd in recent years whose sponsors believed they had put the kibosh on bankruptcy risk by ridding the LBO debt of pesky covenants and issuing pay-in-kind toggle bonds that enabled them to suspend cash interest payments.

"We have a covenant-lite term loan, and a revolving credit facility doesn't have a covenant in it," Stack observed back then. "We don't expect to have any covenant issues, given the current capital structure we have in place."

Last month, Aleris spiraled into Chapter 11, a victim of deteriorating demand and intense cost pressures. The lesson: Many of the ingenious anti-default defenses that private equity firms built into their deals at the height of the LBO boom will prove powerless to deflect the current economic storm.

Aleris is the largest of 25 PE-backed corporations that, according to The Deal, have filed for bankruptcy protection globally so far this year. Credit analysts expect the pace of failure to quicken as the year wears on.

One reason, says Standard & Poor's managing director Nick Riccio, is that the stratospheric debt levels of many LBOs done from 2005 to 2007 primed many targets for a fast and brutal fall: "My guess is that the shelf life for a leveraged buyout seems shorter" than in previous recessions, he says. "The reason is that LBOs were more levered than in the past. You didn't see deals leveraged at 8 or 10 times debt-to-Ebitda in the 90s."

"When you have that much debt, it's not forgiving when things go bad," Riccio says.

The latest crop of busted PE-backed businesses has few surprises. Many operate in sectors hit especially hard by the economic downturn, such as retail and automotive.

Many are smallish and obscure outfits with weak competitive positions in their industries. Only two are in the billion-dollar-plus category: Aleris, in which TPG stands to lose its entire $849 million equity investment, and Masonite International Inc., a doormaker that Kohlberg Kravis Roberts & Co. bought for $2.7 billion in 2005.

Both S&P and credit-ratings rival Moody's Investors Service expect the default rate among speculative-grade companies to soar to an all-time high by the end of this year -- from its current 5.2% to more than 13%.

"In late 1991 and again in 1992, the default rate peaked out at just over 10%," says Moody's senior vice president, Steve Oman. "It looks like we're headed for record territory."