Distress Still Simmers Beneath Surface

A wave of recent downgrades to sponsor-backed companies demonstrates turnaround investors will continue to find opportunities despite a strengthening economy.

Earlier this month, ratings agencies have cut their views on debt issued by at least four companies with private equity owners. Two of them—DS Waters of America Inc., backed by Kelso & Co.; and Real Mex Restaurants Inc., backed by Sun Capital Partners Inc.—are sinking in the C range, indicating serious risk of default. Two others—Apria Healthcare Group Inc., backed by The Blackstone Group; and Norcraft Holdings LP, backed by Trimaran Capital Partners LLC—remain in the B ratings range, indicating lower levels of financial stress.

Perhaps at greatest risk is Real Mex, downgraded by Moody’s Investors Service Caa3 from Caa2, with a negative rating outlook. Moody’s defines Caa obligations to be of poor standing and subject to very high credit risk.

Cypress, Calif.-based Real Mex, which operates nearly 200 restaurants under a variety of brands in more than a dozen states, is suffering from “deteriorating operating performance and cash flow generation in part driven by declining guest traffic and margin pressures,” Moody’s said, noting that Real Mex also has significant leverage, with debt of more than 7.0x EBITDA. The agency expressed concern that the company might need to restructure its balance sheet in the next six months to 12 months. Sun Capital Partners, a turnaround specialist based in Boca Raton, Fla., bought Real Mex in August 2006 from Bruckmann Rosser Sherrill & Co.

Neither Real Mex nor Sun Capital Partners responded by deadline to requests for comment.

Almost equally stressed is DS Waters, a bottler and distributor of water for home and office delivery, Standard & Poor’s cut its ratings this month to ‘CCC+’ from ‘B’. The outlook is developing. The CCC rating by S&P means that a company is currently vulnerable and dependent on favorable business, financial and economic conditions to meet its financial commitments.

“The downgrade reflects DS Waters’ significant near-term refinancing risk for the majority of its consolidated capital structure,” said S&P’s ratings analyst Jean Stout. The Atlanta-based company has a series of debt obligations coming due in the near term, starting with a credit revolver that expires in October. Collectively, the company will need to refinance more than $525 million by next April and has a term loan coming due in October 2012. Thomson Reuters LPC, which tracks the loan market, put the value of the term loan at $300 million. Kelso & Co., a New York buyout shop, made its initial investment in November 2005.

But DS Waters has continued to grow through acquisition. In November, the company did two deals, buying substantially all of the assets of Mount Olympus Waters Inc. to extend its home and office bottled water delivery business into the Salt Lake City area and buying Echota Beverage Group Inc. to expand into Knoxville, Tenn. It also announced a national rollout for its Athena brand, affiliated with the cancer campaign Susan G. Komen for the Cure, which DS Waters acquired in July. The portfolio company delivers bottled water to homes and businesses in more than 40 states.

Neither DS Waters nor Kelso & Co. responded by deadline to requests for comment.

Apria Healthcare Group Inc., a Lake Forest, Calif.-based provider of home health care services, had its rating cut by Moody’s to ‘B1’ from ‘Ba3’. Moody’s describes B-rated issues as speculative and subject to high credit risk, while Ba rated debt has speculative elements. The agency said Apria had negative free cash flow in 2010, largely because of an outsourcing initiative that failed to meet expectations. EBITDA and free cash flow are likely to be continue to be under pressure, probably increasing its leverage above 4.5x EBITDA, Moody’s said, as the company reverses the breadth of the outsourcing initiative. Blackstone took Apria private in October 2008.

Norcraft Holdings LP of Eagan, Minn., was cut by Moody’s to ‘B3’ from ‘B2’, because of concern that the company will have difficulty in generating sizeable levels of operating profits and free cash flow because demand for residential cabinetry, Norcraft’s primary product, will remain weak. Moody’s said it expects leverage to move toward 7.0x from 5.9x at the end of the company’s fiscal 2010. Trimaran Capital Partners acquired Norcraft in October 2003.

And the $45-billion take-private of the Texas utility Energy Future Holdings Co. (formerly TXU) led by Kohlberg Kravis Roberts & Co., TPG Capital and Goldman Sachs’s GS Capital Partners in 2007—had several tranches of its debt—various cash-pay, PIK and Series P notes—lowered to ‘D’ by S&P as the company issued new debt that will give it additional time to repay. Energy Future Holdings floated new $406 million senior secured second-lien notes due 2021 to retire the other debt. S&P assigns the ‘D’ rating to issues in default.

The agency gave a ‘CC’ rating to the new second-lien notes, suggesting the target of the world’s biggest LBO remains highly vulnerable.