Former Bain Capital chief Mitt Romney’s presidential campaign has brought forth a withering critique of private equity, putting the industry under a media microscope. The knock: Romney’s rivals and critics contend that private equity has created a disproportionate number of defaults and question whether PE firms have enriched themselves via dividend recaps while leaving these companies starved of capital.
While LCD strives for non-partisan balance, we thought it would be enlightening to examine the facts based on our ringside seat in the LBO arena, having tracked leveraged loan performance for 15 years, with data dating to 1997.
We’re not in a position to comment on job losses at companies owned by private equity firms, but as for the other criticisms, the data speak for themselves: the default rate of private-equity-backed issuers is lower than that of corporate speculative-grade deals.
Sponsors have skin in the game, and they’re out to protect it, so they’re typically more aggressive about fixing the balance sheets of troubled companies in their portfolios. As for the criticism that PE firms bleed cash out of companies through debt-financed dividend recapitalizations, the data show that such deals consistently have lower initial leverage, and therefore lower default rates than those seen in the broader market. We’ll take each of these points in turn.
Default rates: sponsored versus non-sponsored issuers
The default rate of sponsor-backed loans tracks that of corporate speculative-grade loans, but at a lower level.
The average default rate of private-equity-backed loans between 1998 – the beginning of our data series – and 2011 is 3.97%, versus 4.62% for non-sponsored deals. A caveat: we are not qualified to say whether this rate is lower simply because PE firms are good at picking companies in which to invest. Clearly, that’s not always the case. For every home run like Skype – purchased for $2.75 billion and sold to Microsoft two years later for a tidy $8.5 billion – there’s a stumble like TXU.
What’s clear, however, is that PE firms are nimble in the use financing techniques to create breathing room for troubled companies, particularly through the use of distressed exchanges, getting debtholders to agree to take a haircut on their original investment in order to sidestep a default.
To be sure, adding back those distressed exchanges would raise the historical average default rate of sponsor-backed deals by 1.81 percentage points, to 5.78%. And if distressed exchanges were added to the default rate for corporate leveraged loans, the corresponding increase would be just 0.3% points, to 4.92%.
Looking at the data a different way tells the same story. Of leveraged loans originated between 2005-2008, 7.4% of sponsored paper defaulted, versus 9% of corporate paper. Add back distressed exchanges and the rate would be virtually identical, at 9.5%/9.7%.
The big difference here reflects the fact that issuers behind many multibillion-dollar LBOs from the height of the 2006-2007 credit boom have avoided bankruptcy – thus far at least – by dint of a distressed exchange. Here are the 10 largest:
Dividends deals
For many observers, recaps are the epitome of private equity excess. These deals, after all, allow the sponsors to get a portion – and sometimes a multiple – of their initial investment back while saddling the issuers in question with more debt to repay. In fact, dividend recap deals historically have returned 87% of the original capital invested in LBOs, on average. But while it’s undeniable that recaps are a boon for PE firms, the data don’t support the argument that they are a bust for issuers and debtholders, a topic that has come to the fore amid the recent scrutiny of Romney-era deals such as GS Industries and Dade International.
After all, lenders hold all the keys; they have to be convinced that the company is sound enough to warrant layering in more debt to fund a dividend. So there is a clear positive bias at work. On average, dividend transactions are less geared than the average leveraged financing, as this chart demonstrates:
For this reason, perhaps, dividend deals generate lower default rates than do deals for other purposes. Since 1998, the average cumulative default of dividend recapitalization deals is 7.12%, versus 8.76% for non-dividend transactions. Drilling down to riskier deals – those that were initially rated single-B – dividends still produce a lower default rate: 7.46% to 8.72%. – Steve Miller
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