Default threat grows as debt market worsens

The recent default by The Wornick Co., a Veritas Capital portfolio company, highlights the fact that five of the 10 U.S. companies that have defaulted on their debt in 2007 are owned by buyout firms, according to ratings agency Standard & Poor’s.

What’s more, as of July 31, at least 29 of the 89 companies on S&P’s Weakest Links list (a ranking of companies that are at high risk of defaulting on their debt obligations) are owned by buyout firms and, collectively, have more than $17 billion in publicly traded debt, according to S&P. To make the S&P Weakest Link list, companies must have speculative corporate credit ratings of B- or lower with negative implications. Negative implications indicate S&P’s belief that a further downgrade is likely. S&P reports that between 1981 and 2006, 10% of all entities rated B- have ended up in default within a year of attaining that rating.

These companies include The Carlyle Group’s Water Pik Technologies Inc., Cerberus Capital Management’s IAP Worldwide Services Inc. and Oak Hill Capital PartnersDuane Reade Inc. (See a partial list of the S&P Weakest Links on pages 6 and 8).

The credit crunch could well contribute to a rise in default rates, since it’s doubtful that companies will be able to refinance their way out of trouble. “Saving companies from default could end up depending on the amount of cash a private equity firm has, and its willingness to invest more equity in troubled businesses to fix their balance sheets,” says Rick Antonoff, a bankruptcy and restructuring lawyer in the New York office of Pillsbury Winthrop Shaw Pittman. “If the firm is not able or willing to invest, then the companies will suffer.”

Of course, pouring more equity into a company guarantees a smaller return for an investor if the company pulls through, and it puts more money at risk of turning to dust if it doesn’t succeed. In fact, due to the borrower-friendly debt terms that have flooded the market, there’s a risk that sponsors will find their troubled portfolio companies too far gone to fix.

“By virtue of the extra latitude that borrowers are enjoying today from generous terms, there’s a chance that we’re going to have bankruptcy cases filed in the future for companies that are in far worse shape than companies have historically been in when they’ve had to file for Chapter 11,” says Mark Bane, a co-head of the restructuring practice at Boston law firm Ropes & Gray.

The most recent portfolio company to fall into default was Wornick, a provider of long-shelf-life foods, such as MREs (Meals, Ready-to-Eat), used by the U.S. Military. Veritas Capital, believed to be investing from a $300 million fund III, bought Wornick in late 2003 for $155 million, shortly after the onset of the Iraq war. Robert McKeon, president of Veritas Capital, said that he expected the company’s cash flows to remain strong given the military’s reliance on packaged foods; Wornick’s MRE division accounts for about 70% of the company’s revenue.

Executives at Veritas Capital and Wornick did not return calls seeking comment.

But stunted by a drop-off in federal contracting, the Veritas Capital-owned company failed to make an interest payment on its senior secured notes due July 16. On July 24, S&P dropped Wornick’s corporate credit rating to D from CCC-. A D rating reflects S&P’s belief that the company will default on most or all of its obligations. Meanwhile, the company hasn’t filed its quarterly and yearly earnings reports on time since the third quarter of 2006 due to changes in management and because of financial disruptions, including the closure of one of Wornick’s operating facilities.

Other buyout-backed companies that have defaulted on debt this year include Port Townsend Paper Corp., owned by Northwest Capital Appreciation, and which filed for bankruptcy in January after the paper producer defaulted on its loans; Remy International Inc., a Court Square Capital Partners portfolio company, which defaulted on a semiannual $7 million interest payment due April 15 as part of its $150 million bundle of senior subordinated notes; aluminum products manufacturer TK Aluminum, a portfolio company of AIG Global Investment Corp., CCMP Capital, Private Equity Partners SGR and Questor Management; and InSight Health Services, which entered and exited Chapter 11 earlier this year. Prior to filing for bankruptcy, J.W. Childs Associates and The Halifax Group owned 73.3% and 20.2% of InSight, respectively.