The crisis that has afflicted the financial world over the past two years has arguably been the worst for a generation, but the impact on private equity portfolios, whilst certainly not benign, has been nowhere near as bad as first feared in the dark days that followed the banking collapse in September last year.
Certainly buyout houses have been and continue to wrestle with issues in portfolio companies, cutting costs and preparing them for leaner times, whilst simultaneously facing the prospect of large swathes of their equity being under water, but it is more of a squeeze rather than a wholesale collapse.
One of the measures through which to judge the scale of the impact on private equity portfolios is default levels. Yet these have been pretty low, given the speed at which the European economy nosedived. The leveraged loan default rate in the US stood at 8.4% over the 12-month period to July 2009, according to Moody’s figures, lower than the 8.5% rate in June. The rates in Europe are lower and Moody’s now forecasts that they will stay lower over the medium term compared with the US. These default rates are clearly much higher than we’ve seen over the last several years, hovering as they have around the 2% mark, but that rate in itself was low by historical standards.
We have, of course, seen a number of private equity-backed companies go into restructurings already. Oak Hill Capital Partners recently had to inject £100m into Firth Rixson to reset its covenants and pay off some of the company’s existing debt; EQT recently put €115m into Sanitec, with the lenders agreeing to reduce the debt from €969m to €300m in return for a 22.5% stake in the business; Candover’s Alcontrol is currently in restructuring negotiations; and Dubai International Capital faces a September deadline to reduce the debt in its portfolio company Almatis.
There are plenty more, although most have been in sectors which have been affected the most by the downturn. There will be more to come. “The surge in new restructurings that came to market in late 2008 and through the first few months of 2009 has slowed a little, although it’s pretty clear that this is just timing and that there will be a further slew of restructurings in the second half of 2009,” says Simon Tilley, managing director at Close Brothers Corporate Finance.
“Some sectors, particularly industrials and consumer, still face significant challenges and these are sectors that have been popular with the upper middle-market and large-cap sponsors. There is a large number of highly-geared companies operating in the space that will be facing significantly tightening covenants and liquidity over the remainder of this year and into next.”
“The defaults we’ve seen so far have been companies in highly cyclical sectors with major structural or operational issues or that have run out of cash – something that can happen very quickly,” says Michelle de Angelis, senior director in Fitch’s leveraged finance division. “Given the limited options available to senior lenders, they find their interests more aligned with sponsors and so covenants are actively amended or waived in hope more favourable operating and capital market conditions in the future. This is likely to suppress default rates, though problems still remain.”
Liquidity drain
Indeed, there are a lot of factors that are different from previous downturns and many of these are conspiring to keep default rates at bay. One of these is the fact that lenders are currently capital constrained. “It’s an interesting time right now because we’re in an environment not just of an economic recession, but also of a liquidity crunch,” says de Angelis.
“Ordinarily, if a company needed restructuring, there would be liquidity available either from the banks or vulture investors to finance the restructuring of the distressed company on the basis of a new business plan and a new capital structure.” Under normal circumstances, if the amount of debt in a company exceeded its value, the lenders would take control, take a write-down of the debt for an equity stake and inject more capital as necessary.
“But it’s been different this time,” says de Angelis. “We’ve had a first wave of restructurings in which the usual sources of liquidity weren’t there. The senior lenders were constrained by either lack of capital, because of ongoing deleveraging among banks, or for CLOs (collatorised loan obligations), restrictions on investing new money into risky credits. Consequently, senior lenders had to accept expensive terms from sponsors who could offer new money, including debt write-downs, while the sponsor would retain the majority of equity and, thereby, the potential upside.”
Yet this has changed as some senior lenders are now seeking to protect their positions. “Creditors are taking a harder line stance in this restructuring market,” says Tilley. “Some, particularly the banks and some of the loan-to-own funds, are increasingly seeing themselves as providers of liquidity and medium-term owners of businesses and so in many cases are willing to accept debt-for-equity conversations as a restructuring solution. It means they take a hit now, but get the upside over the medium term. And there’s a lot of logic to the banks playing this as a medium term game.”
PAI Partners recently found this to their disadvantage. After several months of discussions with Monier’s creditors, and a series of offers made by the private equity house, the lenders, led by TowerBrook Capital, Apollo Management and York Capital, took control of the business. TowerBrook also took control of Autodistribution earlier in the year.
While this is far from the outcome that many private equity houses would seek, it may not be the catastrophe it could have been in previous downturns, largely because of the refinancing trend we saw in the mid-2000s.
“Some sponsors are approaching restructuring in a very consensual way and this can sometimes be constructive, although they are having to take a pragmatic view about whether to put in more equity,” says Rachael Luxton, a restructuring expert at Augusta & Co. “In some cases, where firms have taken sizeable dividends in the past, they may well be happy to hand over the keys rather than put in more equity.”
Clearly, these deals have been led by the more aggressive distressed debt specialists, some of which have a loan-to-own strategy. Many banks are likely to be more wary about taking equity stakes. “Banks are generally not in the business of running companies, particularly as there are regulatory issues associated with that,” says Colie Spink, managing director at Alvarez & Marsal. “The minute a bank loan becomes equity, it consumes a lot of capital, and banks can’t really afford to do this because of the minimum capital requirements stipulated by Basel II. Also, they don’t have the bandwidth – their workout departments are grossly overworked and there are not a lot of people with the right experience because of the benign environment we have come out of.”
He adds: “This is one of the chinks in the armour that equity holders will use in their negotiations with lenders.”
Band-aid solutions
Yet there are many who believe the worst is yet to come. One of the issues is that many of the big deals completed in the run-up to 2007 were done on a covenant light (cov-lite) basis and contained little amortising debt. “Cov-lite structures and bullet loans are a concern because the company has to underperform seriously before there is a catalyst for people to get around the table,” says Tilley. “This situation requires proactivity on the part of the shareholders. They need to be cost-cutting, making investment decisions and generally taking measures to ensure that the company can work within its capital structure. But there is a danger that these companies are allowed to drift, which would be storing up trouble for the future.”
“The response to the issue is mixed,” says Spink. “A lot of the refinancing is being addressed with band-aid solutions – maturities are being pushed out a little and covenants are being waived. This is largely driven by the banks’ inability to deal with the problems that are on their way.”
The other major point is that because company performance is generally nowhere near the projections on which the debt packages were usually based, the de-leveraging process that you’d normally see following the deal has not been happening – companies haven’t had the cash to pay back the debt. That is fine until the debt reaches maturity.
“No companies in our shadow portfolio could repay all their debt through cash flow before final maturity, so they all face refinancing risk,” says de Angelis. “Based on Fitch’s own forecasts, the portfolio average leverage could reduce debt to 5.5x EBITDA by 2012, which is when the wall of refinancing really hits. That’s above the 5x average debt multiple the bank-driven market tolerated prior to the onset of CLOs and hedge funds as syndication targets in 2004. It’s a serious matter when the primary market is only financing 4x for a new deal today.”
Figures from both Fitch and Standard & Poor’s suggest the peak of maturing debt will be 2014, although the amount of debt due for repayment will start rising sharply in 2012. In 2014 alone, S&P estimates that around €125bn of leveraged buyout debt will be maturing. The main issue is where the capacity to deal with this will come from.
“Sponsors are taking action on refinancing risk through debt buybacks and coordinating amendments and wavers with bank in order to buy time for further de-leveraging,” says de Angelis. “However, the senior debt market will take a long time to recover as CLOs no longer have cheap funding to finance their senior notes and banks continue to de-leverage.
High yield hope
Some are pinning their hopes on the high yield market. Terra Firma’s EMI is currently working on a £200m to £280m high yield bond issues to repay debt and Wind Telecommunications sold €2.7bn of notes recently. Yet others believe this is unlikely to be the answer.
“Many of the private equity-backed companies still have a long time before they reduce leverage to acceptable levels, and high yield will certainly be more expensive than the current debt arranged during the boom,” says de Angelis. “Moreover, the high yield market has tended to favour BB companies, whereas most LBOs are rated at the low end of single-B. In addition, high yield investors tend to favour well known names in defensive or robust sectors such as healthcare, cable and mobile. Just to be considered for a high yield bond, companies will have to focus on paying down debt with free cash flow in the interim.”
With so many companies either staving off restructuring because covenants haven’t been triggered, or with banks reluctant to restructure all but the most urgent cases, it looks as though today’s problems could well be deferred to tomorrow. The problem is there is already huge uncertainty surrounding where the finance for all the debt that comes to maturity over the medium term will come from. No-one knows quite what is going to happen, but it’s highly likely that whatever does, there is an awful lot more trouble in store for private equity portfolios, particularly in the mega-deal b
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