The note also questions whether these refinancings, rather than strong management teams installed at private equity portfolio companies, are responsible for higher private equity returns.
Because of cheap debt and abundant liquidity, the rating agency asks what the benefits are for taking a public company private, when it seems private equity is focused more on refinancings than long-term investment in a business it has bought.
Moody’s also highlights the lack of transparency among private equity firms, making it difficult for it to gauge the true risks associated with their transactions.
“The current environment of significant private equity deal volume, along with the very large size of some transactions, highlights concerns for Moody’s analysts regarding the review of private equity sponsored transactions,” the note begins.
“Future performance of current transactions will likely hinge on the economy remaining relatively stable and the credit markets remaining forgiving as many of these transactions will need to be re-financed over the coming years.”
Moody’s is sceptical of private equity plans to de-leverage their portfolio companies or exit through the IPO market when favourable debt market conditions “provide ample opportunities for dividend distributions” through refinancings.
“Of concern to Moody’s is the willingness of private equity firms to issue special dividends despite commitments to reduce leverage, sometimes within twelve months of the transaction’s closing,” Moody’s says.
“The reason for the dividends – whether pressure to increase returns, because the market’s liquidity allows for such transactions, or something else – is not always apparent.
“Future performance of many of these transactions will likely hinge on the economy remaining relatively stable and the credit markets remaining forgiving as these transactions will need to be re-financed over the coming years.”
Moody’s says it has seen the equity component of private equity owned issuers diminish due to these dividends, “sometimes completely eliminating the amount of contributed capital in their investments.”
Moody’s believes “the current environment does not suggest that private equity firms are investing over a longer term horizon than do public companies, despite not being driven by the pressure to publicly report quarterly earnings.”
“We also question whether there is sufficient evidence to prove that the higher returns provided to private equity are driven by stronger management teams or because, in a benign and liquid credit environment, leverage by itself can provide substantial returns to shareholders….
“We are less optimistic about the willingness of the private equity firms to inject capital in the future, if necessary, at a rate different from that of a strategic owner/operator would. In fact, there are circumstances in which we think that private equity would have less incentive to do so.
“It is likely that the credit impact from private equity transactions will be more ambiguous going forward. Much private equity capital has been raised and needs to be invested.
“We note that generous levels of market liquidity driven, at least in part, by the unusually low level of defaults (near 12 year low as of June 2007) have led to investors showing less discrimination regarding credit quality, as evidenced by the increase in very low rated debt being issued on generous terms.”
Moody’s “is concerned that debt holders have less rights given the prevalence of no or minimal financial maintenance covenants and modest amortisation requirements among current transactions.”
For Moody’s, some of its concerns over the LBO market are unlikely to be resolved because of a lack of transparency in the industry.
“For example, in Moody’s view, a sponsor’s equity contribution in a leveraged transaction (LBO or acquisition) may not necessarily become a permanent part of the company’s capital structure.
“We note that the amount of capital contributed tends to fluctuate at least in part because of several exogenous factors that analysts have little ability to measure: the financial needs of the overall fund of which this investment is one part, and the relative liquidity of the capital markets and opportunistic financing offered the firm.
“Moreover, we believe underperformance by a particular issuer in a private equity firm’s portfolio can impact other issuers in the fund. If deterioration at one investment constrains a return of capital, it puts additional pressure on other firms in the portfolio to compensate.
“As a result and despite certain strengths that sponsors often contribute (i.e. management depth, sophistication, access to capital) Moody’s remains cautious of the merits of private equity capital contributions, although corporate family ratings to date generally reflect the impact of the equity component of a transaction.
“However, while companies often commit to de-levering, execution is not consistent. If in the past Moody’s did assume that a private equity firm’s exit strategy would be the IPO market or sale to a strategic operator, this is no longer the case.
“In times when the IPO market is less receptive or the credit market particularly generous, issuers have re-levered and returned capital with “one-time” (although potentially several) dividends.
“However, we do believe it is more likely that the larger the equity investment, particularly versus other same-fund investments, the more motivated the private equity firm to insure the overall success of the company….
“Alternatively, we often see the benefit of a divestiture from a large corporate entity and recognise the opportunity to take private an under-managed subsidiary where at a minimum corporate expenses can be removed. We also remain open minded regarding transactions with issuer-specific advantages such as real estate opportunities in the retail sector.
“However, we remain mindful that the ultimate beneficiary of these advantages may be the private equity firm.”
Separately,
Seven out of 10 respondents believe that there is room for further increases in the debt multiples being employed in European buy-outs.
The UK, Germany and France, in that order, are pinpointed as the markets that will be the most active in the next six months, with consumer products and services leading the way as the sector most frequently predicted to be the most active during the same time period.
Deborah Cust
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