Night of the LBO Dead
Linguistic innovation has grown apace with financial creativity in recent years. "Covenant lite" has morphed into "zombie", the term for what a Financial Times article of March 25 described as "companies with unsustainable financial structures but no triggers for the banks to force them to renegotiate."
Their debt is trading below the 80% which has become increasingly standard for leveraged loan paper, and the companies are now deemed to be worth less than what they owe. Banks who did the deals (or still have the debt on their books because they couldn't offload it when the credit crisis hit), and investors who bought the debt, in most cases have no ability to renegotiate the terms to salvage their investments: they were "covenant lite" or even no covenant at all.
The FT gives the examples of Spain's clothing retailer Cortefiel, Irish telecom company Eircom (into its second round of financial pillage) and Germany's plastics company Klöckner.
But there are more. Exactly how many more cannot be determined, any more than the securitized debt trail can be fully traced. One indication of the extent of the contagion is a recent report from Standard & Poors's which maps the corporate default threshold. According to the study, the number of "weakest links" - companies closest to default on their financial obligations - stood at 114 on March 10, with 93 of them in the US. In June 2007, the comparable number was 62, rising to 77 in December.
Of the 93 US "weakest links", over half were involved in private equity transactions. Standard & Poor's finds the results "not surprising", given that companies taken private through an LBO depend on taking on additional debt to deliver returns to investors. "The default risk exposure may be magnified this time around, because current market conditions have constrained the typical exit options afforded to sponsors", observe S&P. That is to say, the "exit" door is currently blocked, consigning the acquired companies to longer private equity ownership - a point emphasized by the IUF at the onset of the credit crisis.
Another recent study by FridsonVision, discussed in the Wall Street Journal on January 25, looked at 220 private equity deals between 2002 and 2007, and found the level of "distressed" debt to be 29%, including bonds and loans, compared with a level of 19% in the Merrill Lynch high yield index. The study also found widely varying levels of distressed debt between the various buyout firms, with Thomas H. Lee Partners (47%), Apollo Management (42%) and Bain Capital (42%) scoring at the top.
S&P and Moody's both predict a substantial increase in the default rates for LBO-related debt.