During the Great Panic, there was some grumbling that private equity-backed companies were posing a great risk to the economy.
The Private Equity Council has done some research and came to the conclusion that the opposite is true. They are less likely to default.
Of course, there are lots of caveats and distinctions in the report. Of course, there is my own disclosure since I work in private equity.
One issue is how you define a “default.” The Private Equity Council use the the ISDA’s definition in credit default swap contracts: (1) a missed payment or (2) a bankruptcy filing.
They exclude exchanges where the borrower buys back debt at a discount or swap the debt for equity. You can make an argument that these types of exchanges are opportunistic, and not a genuine attempt to avoid a bankruptcy filing. After all, if the company were really in such bad shape, why would the private-equity backers pour more money into the deal by buying the debt or diluting their equity.
The Private Equity Report was largely in response to a report from the Boston Consulting Group and a second report from Moody’s Investor Service.
Get Ready for the Private Equity Shakeout
The problem with the Boston Consulting Group’s study, Get Ready for the Private Equity Shakeout, is that they used the credit spreads in November 2008. They found that 60% of the private equity portfolio companies had their debt trading at distressed levels.
I have to agree with the Private Equity Council when they find fault with that calculation. Credit spreads were huge for every company in November 2008. The economy was in the grips of the Great Panic for liquidity.
The PEC’s chart shows that the default rates have not held up to the BCG estimate.
$640 Billion & 640 Days Later
The big issue with the Moody’s report is that it includes “distressed exchanges” in their definition of default. More than half of the defaults in the Moody’s study fell into this category. Of those, about 70% were exchanges at less 15¢ on the $1. I would be hard-pressed to say at debt purchase at 90% of par should be considered a default. At 15% you are looking more like a default.
However, the Moody’s report ended up concluding that the 186 LBO deals in the study had roughly the same default rate as similarly rated companies. Where Moody’s found the biggest problem was the biggest LBO deals from January 2008 to September 2009. Six of the ten were considered distressed or defaulted.
On the other hand, the study’s time frame was during the most tumultuous period in the financial markets for decades. Things are much calmer now than they were in September 2009.
What’s Ahead
How should I know? I’m just a compliance guy banging away on his keyboard. But it is hard to ignore upcoming debt maturities. Even though companies may be current on their debt service, all of that cheap debt is going to be hard to replace when it matures.
It is clear to me that we should be skeptical about statements that private equity transactions pose an exceptional risk to the financial system. Those statements are not backed up by the data.
Sources:
- The Credit Performance of Private Equity-Backed Companies in the ‘Great Recession’ of 2008-2009
by Jason M. Thomas - Get Ready for the Private Equity Shakeout by The Boston Consulting Group (December 2008)
- $640 Billion & 640 Days Later by Moody’s Investors Service (November 2009)
