Tag: Private Equity Council

Are Private Equity-Backed Companies More Likely to Default?

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:

Regulating Private Investment Funds

Capital_BuildingLast week the Subcommittee on Securities, Insurance, and Investment of the United States Senate Committee on Banking, Housing and Urban Affairs held a hearing on regulating private investment funds. [You can see an archive of the hearing.] The video shows lots of empty Senator chairs at the hearing.

Senator Reed pushed his Private Fund Transparency Act. Senator Bunning sees some need for more disclosure, but is skeptical that regulation would do much.

Mr. Donohue’s statement gives a great summary of the history of the regulatory approaches to private investment funds and a summary of the current exemption available to private investment funds.

The questions from the Senators also provided some interesting insight of the legislators and SEC. Mr. Donahue’s pitch for regulation was that the Investment Advisers Act was put in place to regulate people who manage other people’s money. Private fund advisers indirectly manage other people’s money.  He does not like the idea of putting private funds under the Investment Company Act. Senator Reed pointed out that bringing private funds under the SEC registration umbrella would require additional resources and technology.

Senator Bunning cut into Mr. Donohue, wanting to know who in the SEC is “smart enough.” The Senator was highly critical of the SEC.

Senator Bayh focused on the international issues and the EU’s Directive on Alternative Investment Fund Managers. He also wondered if over-regulation could lead to forum shopping by fund managers.

Mr. Singh pushed for “smart regulatory framework.” He pointed out the MFA’s Sound Practices for Hedge Fund Managers (.pdf).

Mr. Chanos pitched the idea of having a special Private Investment Company law specifically tailored for SEC regulation of private investment funds. (In my view, the best approach.)

Mr. Loy gave the view of venture capital funds and how they operate differently than hedge funds. He pointed out that venture capital funds do not provide systemic risk.  Senator Bunning showed a lack of understanding of venture capital.

Mr. Tresnowski presented on behalf of The Private Equity Council and showed the differences between private equity and hedge funds. Senator Bunning also showed a lack of understanding of private equity.

Mr. Bookstabber focused on systemic risk.

Mr. Dear gave the viewpoint of an investor in private funds.  He also pointed out the superior returns they have experienced with private investment funds.