This year is seeing an avalanche of corporate downgrades, and private equity investors—following years of torrid private equity activity—are sharing some of the misery.
In the year to date, downgrades have vastly outnumbered upgrades by almost 15 to 1. This is about 3x worse than the previous high reached in 2001, when the downgrade-to-upgrade ratio was about 5 to 1. In 2008, the ratio was 3.4 to 1, and in 2004-2007, downgrades and upgrades were about equal. The bulk of the recent corporate downgrades were in the lower rating categories, and many were ratings lowered to ‘D’ or ‘SD’ as a result of either a missed payment, a bankruptcy filing, or a distress exchange. Private equity investors are significantly exposed to these downgrades, including defaults.
The explosion of buyout activity in recent years inevitably positioned private equity investors squarely in the speculative-grade segment. In their search for yield, sponsors typically targeted troubled entities, or at the very least ones that appear to be, and many of these companies are rated speculative grade. It is in this segment that sponsors are more likely to land an entity with much potential at an attractive price and then, they hope, sell it for a profit after some sort of restructuring or reorganizing. The expertise of private equity groups to identify and rehabilitate entities, at a time when liquidity was abundant and confidence was soaring, worked very well, which, in turn, fueled the use of this model even further.
Sponsors might offer some stability to target companies with their deeppockets and knowledge and experience in managing distressed companies.In fact, some companies may have even averted bankruptcy with the helpof their sponsors. However, some practices that private equityinvestors have adopted in recent years could also have exacerbated thetargets’ balance sheets, particularly if they underestimated theseverity and duration of the current economic and financial challenges.
However, the economic landscape has changed dramatically, and the current recession is bearing down on companies across the ratings spectrum, but is particularly harsh on entities at the lower end. Poor corporate earnings, an apprehensive consumer market, and reduced access to capital have significantly eroded credit quality. Entities rated speculative grade have less financial or operational flexibility and are therefore more vulnerable to further credit degradation.
This is evident in our ratings: speculative-grade-rated entities have not only been more volatile historically, but they also have been more likely to default. On average, during the period 1981-2008, 8.88 percent of entities rated ‘B-’ and 25.70 percent of entities rated ‘CCC/C’ defaulted within a year. This statistic even excludes entities that were downgraded to or were newly rated at the ‘B-’ and below level and that defaulted between calendar years. Although sponsors might have accounted for some of this credit erosion in their valuations, exit strategies (such as an IPO) are less feasible in the current environment, perhaps compelling sponsors to the engagement longer and deeper than they had originally planned.
The number of weakest links—defined as entities rated ‘B-’ and lower with a negative outlook or ratings on CreditWatch with negative implications—increased dramatically to 293 as of May 13, 2009, from just 100 at the end of 2007. The erosion of credit quality leads to lower ratings and more entities with negative outlooks or negative ratings on CreditWatch as well as increased vulnerability to default. Of the 293 weakest links, more than half have been involved in transactions with private equity at one point or another. The vast majority of these entities were previously rated at higher rating categories but have seen significant deterioration in recent months.
Some of these entities were even rated investment grade not too long ago. Weakest links are particularly vulnerable because they tend to have less tolerance for absorbing economic or market stress. Relative to the entire corporate speculative-grade population, it is not a surprise that weakest links would have a larger proportion of entities defaulting, particularly during periods of economic stress. In the 2001-2002 cycle, for example, more than half of the weakest links defaulted within 12 months, and nearly 65 percent defaulted within three years. We expect to see the same trend in the current cycle.
Corporate casualties in 2009 have already exceeded the total in full-year 2008. Similar to the pattern observed among weakest links, at least 79 of the 140 defaulters through May 28, 2009, (74 of the 126 defaulters in 2008) were involved in private equity transactions (see table 3). Sponsors might offer some stability to target companies with their deep pockets and knowledge and experience in managing distressed companies. In fact, some companies may have even averted bankruptcy with the help of their sponsors. However, some practices that private equity investors have adopted in recent years could also have exacerbated the targets’ balance sheets, particularly if they underestimated the severity and duration of the current economic and financial challenges. We forecast more than 200 defaults in the U.S. in the next 12 months, and we expect private equity exposure to these casualties to remain elevated.
The decline of asset valuations on the heels of the economic recession has hurt private equity investors to a certain extent. However, this may have also given sponsors a window of opportunity to further build up and diversify their portfolios. The improved risk-reward potential of some entities with sound business models makes them that much more attractive targets.
Diane Vazza is managing director, and Jacinto Torres is associate director in the New York office of Standard & Poor’s.