First a credit bubble fueled a mid-2000s buyout boom marked by hundreds of highly leveraged transactions. Next a credit crunch struck in 2007 that made it difficult to refinance those loans. And then the topper: the Great Recession rolled in, crushing EBITDA at companies across a broad swath of industries. So where was the inevitable carnage in the form of portfolio company defaults?
Some say to just be patient. Heino Meerkatt, senior partner in the Munich office of The Boston Consulting Group, told me he’s not ready to back away from his well-publicized, late 2008 prediction that more than half of all portfolio companies would eventually default on their debts.
Meerkatt, who works mainly with larger general partners, said his clients have already had to negotiate with creditors on roughly half their portfolio companies. With a peak in debt maturities not expected until 2013 to 2014, Meerkatt said he wouldn’t be surprised to see the default rate reach the 50-percent range. “The jury is still out,” he said.
Still, the U.S. buyout market seems remarkably quiet. For all of last year, Buyouts identified just 63 portfolio companies of U.S. buyout shops that Standard & Poor’s considered to have defaulted on their debt. And for the first two months of 2010, only five portfolio companies have fallen into default. It’s not clear how many buyout-backed companies are tracked by S&P, but those strike me as small numbers.
Anecdotal evidence also suggests that buyout firms have managed to contain the damage. An executive at one buyout shop that owns about 70 companies told me his firm experienced zero bankruptcies last year, pulled its financial support from one company, and had to sit down with lenders to discuss missed covenants in perhaps six or seven situations. Another source closely following the market said that over time your typical buyout shop experiences some equity loss on perhaps 20 percent to 25 percent of its deals, and complete equity losses on about 10 percent. But even after the last two years, he said, “I expect those numbers will pretty much hold.”
So what happened? One of the most overlooked reasons (by those outside the industry) is that many buyout firms got the word out early to their management teams to prepare for the worse and cut costs. “Everyone realized that this was the big one and they hunkered down,” said David M. Brackett, senior managing director, GE Antares Capital, a senior lender that has cultivated a portfolio of some 400 to 500 sponsor-backed companies. In addition, the “overwhelming majority” of sponsors in the GE Antares portfolio, Brackett said, stepped up to provide financial support, whether in the form of additional equity, debt reduction, or guaranteeing revolver loans.
Creditors played a leading role in the soft landing. On the large end of the market, loans had been made on such borrower-friendly terms—think covenant-lite loans, PIK toggles—during the bubble years that many borrowers essentially got a free ride through the recession. By the middle of 2009, with the economy improving, credit markets had warmed to the point that borrowers were frequently negotiating amend-and-extends on their long-term debt. This year we’ve seen the pace of refinancings begin to pick up.
The middle market never saw quite the borrower-friendly terms that the large market did. But there, a different phenomenon aided borrowers. According to Brackett, GE Antares bought debt on the secondary market from antsy co-lenders in about 20 percent to 25 percent of its portfolio companies. This gave the senior lender more influence over bank groups to effect the direction of negotiations with borrowers who had run into trouble. With about 10 percent to 15 percent of its borrowers, GE Antares and fellow creditors ended up offering “more thoughtful, longer-term solutions,” Brackett said, such as waiving covenant breaches or forbearing on penalties, to give portfolio companies some breathing room. “Our inclination is to work through difficult situations with our borrowers and our sponsors,” he added.
Portfolio companies got another break by having had their original senior loans tied to LIBOR, which has remained at depressed levels throughout the recession. “That provided a lot of flexibility for companies when EBITDA compressed,” said Brackett.
Of course, even in the worst of situations portfolio companies don’t necessarily have to default on their debt or file for bankruptcy. Because they typically control the boards of companies, sponsors have the flexibility to, say, sell a struggling company. If the reasons are to try to make creditors whole, and to free up time to focus on better opportunities, doing so may be the most rationale choice for sponsors, according to Jonathan P. Friedland, a restructuring attorney at Levenfeld Pearlstein. Indeed, bankruptcy filings are expensive, DIP financing has been hard to come by, and few buyout firms relish the prospect of a long, drawn-out fight with lenders that they prefer to stay on friendly terms with to secure financing on new deals. That they walk away from their equity stakes in some cases suggests that estimated default rates may understate the actual amount of trouble portfolio companies have gotten into over the last couple of years. Then again, most sources I talked to for this column believe they’ve performed better than anticipated.
“The sky hasn’t fallen,” said Dennis J. Drebsky, a bankruptcy and restructuring partner at Nixon Peabody LLP. “It just sagged a little.”