Loan defaults in 2023 are not predicted to match previous recessions, but a disproportionate amount will come from private equity-owned companies. Cov-lite structures should give them an upper hand in negotiations…
Corporate loan defaults are slowly ticking up and are expected to rise to around 5% in the US and Europe during 2023 – still far below the peak of the global financial crisis.
Nevertheless, as growth slows and interest rates have increased, a wave of debt restructuring among private equity-backed companies is expected to build. Over the past 12 months, a growing number of private equity funds have been capping leverage on their portfolio companies and weighing up loan maturities. A record level of refinancing during 2021 and healthy revenues to date provides a liquidity cushion for many but those with excessive leverage or cyclical exposure will be more vulnerable.
“Some of our competitors have gone for what I believe is excessive leverage and were already faced with thin cash flow cover. Now they are facing top line volatility and a very real increase in interest rates,” says a London-based partner at a private equity fund.
There has been a drift among private equity funds generally over the past three years to less cyclical sectors, a trend accelerated by the pandemic: almost half of the LBO issuance in the year to 30 September has been in the technology sector, according to Leveraged Commentary & Data (LCD). Financial services and business software investments are generally expected perform better in a recession than the consumer discretionary sector, for example, but private equity investments in food and agriculture, supply chain and logistics and energy face an added layer of volatility from the war in Ukraine. According to a recent survey by LCD, energy remains the debt market sector most likely to outperform, followed by healthcare and a jump by technology to third place.
Yet, given their presence in the B3 and below rating category, a disproportionate number of defaults are expected to come from private equity-owned companies. According to Moody’s, 79% of North America companies at B3 or below are currently owned by private equity, compared to only 50% in Europe. Of the 177 companies on the credit agency’s US B3 Negative and Lower List of distressed debt, around 70% are private equity-owned.
The three largest LBO term loans this year belong to borrowers rated B-minus on at least one side — athenahealth, McAfee, and Citrix Systems – representing almost a quarter of the overall LBO loan volume so far in 2022.
Though many private equity-backed companies have refinanced while borrowing was cheap, they also tend to be majority funded with floating-rate debt making them more vulnerable to base rate increases and macroeconomic shifts. Leverage has also been increasing: LBOs financed in the syndicated loan market in the last six months had an average debt/EBITDA ratio of 6.1x, the highest reading since 2007, and up from 5.8x in 2021, says LCD.
The stress point for private equity-backed B3-rated companies in the US comes when rates increase above 3%, according to Moody’s. Rick Fratus, a managing partner at Stafford Private Markets in the US, likens the situation to a “slow-moving car crash” as GPs try to reposition companies in their portfolio.
“I wouldn’t call this a crisis yet,” he says, “companies are managing and I don’t think they’ve been hit on the earnings side so what’s happening is being taken on board. We know that some of the companies are in trouble right now. The [private equity] deals that were done in 2021 and at the beginning of 2022 are struggling with some of the debt that they’ve taken on with the rapid increase in the rates.”
Unlike the global financial crisis however, credit funds – seeking distressed debt, special situations or direct lending – have a greater opportunity to steer this slow-moving car before impact.
In a market commentary note at the end of September, Oaktree Capital – which raised $16 billion last year for its largest-ever opportunistic credit fund – said it believes the current expansion of the distressed credit universe could prove to be more long-lasting than during the pandemic in 2020. Private equity sponsors facing the risk of loan default in their portfolio companies are likely to find themselves competing with distressed debt investors to retain control of these businesses, once cost-saving initiatives have been exhausted. They may have an advantage though in the sponsor-friendly covenant-lite documents that now dominate the market. These looser credit documents provide a greater opportunity for sponsors to restructure financing without lender consent and to preserve their equity where possible.
“Sponsors now expect to have to do the thinking themselves,” says a private equity lawyer based in London in relation to the syndicated loan market, “and correspondingly, they expect to be able to deploy the solution that they come up with without needing all their lenders’ blessing.”
Where sponsors are working with credit funds – which traditionally avoid ‘taking the keys’ when a company gets into financial difficulties – even more thinking is likely to result, especially given some of those credit funds may have loan repayment problems in their own portfolios too.
