In this piece, we survey publicly rated North American corporate entities that experienced a selective default and a subsequent rerating since the start of 2022, when the credit markets began to stall. We examine common factors that led to an 'SD' rating, the duration entities remained at that rating, and the distribution of ratings after we rerated them. We also highlight instances of repeat defaulters and, lastly, comment on the two sectors most represented among entities that experience a selective default.

Growth Of Private Equity-Owned Companies

The decade-long, rock-bottom benchmark rates following the Great Financial Crisis (GFC) resulted in institutional investors pursuing higher yielding asset classes. In the last decade, allocations to PE and other alternative assets grew with high velocity. In the U.S., PE assets under management grew to $3.3 trillion in 2023 from $1.1 trillion in 2012, based on data from Pitchbook. An increase in PE ownership among companies we rate in North America also reflects this rapid growth.

Of our rated North American, speculative-grade, corporate companies, 623 (about 49%) are sponsor-owned. For companies rated 'B' or lower, that percentage jumps to 73%. Of these sponsor-owned companies, health care, capital goods, and high technology sectors constitute 43%.

The gradual change in the ownership profile of companies also led to more companies favoring out-of-court restructurings over traditional bankruptcies. This preference stems from high direct and indirect costs and time associated with bankruptcies (prepackaged bankruptcies may be an exception), as well as other business factors (supplier cut-offs, reputational issues, employee turnover, and morale). Another reasoning includes the risk of more immediate payment claims, such as unfunded pensions, could get pulled forward in a bankruptcy.

A key driver, though, for sponsors' desire to engage in an out—of-court restructuring over bankruptcy is to retain ownership and not relinquish control to lenders. This preserves their equity investments, which, in a bankruptcy, will likely be wiped out by claims from the lenders.

In the past decade or so, S&P Global Ratings observed a gradual rise in 'SD' ratings due to the increase of PE sponsorships, and thus out-of-court restructurings--generally through a distressed exchange. Depending on the nature of the out-of-court restructuring, we could either lower our rating on the entity to 'D' (default) or 'SD', though not all such restructurings result in either one or the other (see "Credit FAQ: When Is A Restructuring Viewed As A Selective Default?", published Oct. 15, 2024). A distressed exchange could be a general default if it affects a large portion of the capital structure.

Since 2021, selective defaults have taken over as the largest percentage of total defaults (see chart 1). This stems from an uptick in distressed exchanges, which have been increasing over the past decade to more than 60% of total defaults so far in 2024, compared to only 29% in 2014.

Chart 1

Chart 2

Use Of Defaults And Selective Defaults

We lower a rating to 'D' or 'SD' based on its assessment of the original promise to pay its debt obligations. We lower an issuer's credit rating to 'D' if the entity's default is a general default on the capital structure and believe that the obligor will fail to pay all or substantially all its obligations as they become due. In contrast, an 'SD' rating is assigned when an issuer defaults on one or a class of obligations but remains current on payment on the other issues. For our credit rating purposes, a distressed debt restructuring generally constitutes an 'SD' rating, absent adequate offsetting compensation.

Our methodology establishes two conditions to lower our rating on an issuer to 'SD':

• First, the issuer is distressed. In other words, we believe that in the absence of such restructuring, there is a realistic probability that the issuer will experience a conventional default.
• Second, the investor is not adequately compensated for the exchange and receives less value than initially promised.

Once an issuer rating has been lowered to an 'SD', we will review the company's revised capital structure and creditworthiness, then rerate it based on its modified terms and capital structure.

Drivers Of Selective Defaults

Extending payment maturities was the top theme that emerged from companies that restructured after they were downgraded to 'SD'. This is not surprising given the uncertainty in the magnitude and timing of the Federal Reserve's policy rate movement the past two years. The uncertain economic outlook led to different views on company valuation and pricing between PE sponsors looking to exit and buyers (strategic and other sponsors). PE sponsors postponed asset sales, which in turn led to the execution of amendments to push back near-term loan maturities of distressed issuers, which we consider a selective default.

Another recurring theme was conversion of cash-based payment interest to PIK interest. This is also a function of the economic environment as the rising benchmark SOFR rate, which put significant pressure on issuers' ability to meet their debt-servicing costs. For the highly leveraged, distressed lenders in this space, liquidity and margins came under intense pressure, which in turn led to amendments executed to convert cash pay interest obligations to a partial or full PIK of their interests.

Other common themes that led to an 'SD' rating includes issuers making a below-par tender offer or a below-par exchange, collateral transfer that caused senior lenders to become structurally subordinated, introduction of a super senior lender that contractually subordinated senior lenders, and equitized lender's debt.

Although liability management transactions that caused unequal outcomes to lenders have drawn a lot of scrutiny, they were not the primary drivers of selective defaults.

A breach is a breach, no matter the number of modifications

Companies engaged either in a significant alteration to the terms of payment or modified just a single term. Irrespective of the number of changes to the terms, we deem even a single breach in the original terms of payment for a distressed entity as a selective default if the lenders are not adequately compensated.

For instance, in June of this year, Premier Dental Services Inc. (Sonrava Health) made several modifications to its terms of payment to address near-term liquidity issues. These included exchanging existing first-lien term loans and its revolving credit facility for second-out term loans, converting a portion of cash interest to PIK, and pushing back scheduled principal amortization.

Valcour Packaging LLC, which manufactures and supplies plastic packaging components, executed a transaction earlier this year to exchange its existing debt for new debt at a discount to par. It also provided an option for tranches to exchange cash interest to PIK and introduced a new super senior loan that structurally subordinates the erstwhile first- and second-lien loans.

On the other hand, there were instances when an 'SD' rating resulted from a single modification in terms of payment. For instance, talent acquisition service CareerBuilder LLC executed an amendment to its term loan last year, extending the loan facility's maturity by three years to July 2026. We viewed this as a distressed transaction that was executed to avoid a payment default, given the issuer's weak liquidity and cash burn.

Similarly, when Quincy Health LLC, a hospital and outpatient services provider, amended its term loan to allow for PIK, we viewed it as a distressed exchange. This was because the change in terms came from an entity in financial distress. In both instances, lenders were not adequately compensated for exchanging cash interest in lieu of PIK payment.

How Long Is An Entity Rated 'SD'?

After downgrading an entity to 'SD' following a distressed exchange, we reevaluate the company's creditworthiness under the revised capital structure and terms of payment. We strive to rerate from 'SD' at the earliest opportunity after we have adequate information about the modified terms and capital structure. To get a better sense of short-term liquidity needs, we typically we look for updates on business performance and outlook, as well as review investors' participation in the offer.

Chart 3

In our sample of issuers that experienced a selective default, we rerated about 29% within five days. The median time an entity stayed at 'SD' was 10 days, while the average time was 16 days. The average was longer because, for a handful of entities, we sought more information and clarification before we could rerate out of the 'SD' level.

Rerated Following A Selective Default

We rerated about 85% of the companies into the 'CCC' rating category after a selective default. In our view, the capital structure for this overwhelming majority of companies remained unsustainable even after restructuring, and we envisioned another default (or selective default) as our base case. Our credit view has been borne out by studies we did on the performance of entities lowered to SD (next section).

Chart 4

Redefaulters And Worse

Of the 77 entities rated 'SD' since the start of 2022, 21 experienced a second selective default or a general default/bankruptcy. All entities that experienced a second default or selective default we had originally rerated in the 'CCC' rating category or lower following the first selective default. The rerating to the 'CCC' rating category was, in retrospect, an appropriate reflection of our view of an unsustainable capital structure--even after restructuring. Of the companies that defaulted again, seven experienced their second default within six months. Overall, the average time between the two defaults was less than a year.

While a revised capital structure may provide some reprieve, highly leveraged entities with fundamental operating and liquidity issues will not get the runway that an out-of-court restructuring may provide. Two of the entities that experienced a selective default filed for bankruptcy in less than a year. This recent experience of repeat defaulters is consistent with other studies we have done.

Globally, we find that lender-led, out-of-court restructurings do not necessarily result in permanent solutions. Since 2008, more than one-third of issuers that initially selectively defaulted have subsequently defaulted again. In 2023, 35% of total global defaults were by issuers who had at least one previous default--the second highest percentage since 2008. So, although we experienced an elevated number of defaults in 2023, many of those issuers defaulting were doing so for a second, third, fourth, or even fifth time. Additionally, more than half of these issuers were rerated again following their 2023 default. In essence, the cycle continues (see "The Rise of Repeat Defaulters", published April 11, 2024).

Sector Breakdown Of Selective Defaults

The rise in defaults that began in 2022 has been concentrated within the health care and the media, entertainment, and leisure sectors. These two industry groupings alone accounted for 38% of total 'SD' ratings.

Although companies in both sectors have seen more defaults overall due to economic and sector-specific challenges, they have also seen an increase in the percentage of selective defaults.

Chart 5

Generally, the demand for health care services was robust through the pandemic and its aftermath. Larger primary health care providers particularly fared well. However, outcomes for service and equipment providers that supply primary health care providers have been decidedly worse. These subsectors tend to consist of smaller, speculative-grade companies with narrower margins. In many cases they simply did not have a cushion to sustain the rising wages that came along with the tightening labor market, let alone the rising debt-servicing expenses associated with highly leveraged capital structures common among many of these operators. Although there seem to be early indications that costs are finally stabilizing, it will likely take until next year before these subsectors are back in balance.

Within the media, entertainment and leisure sector, defaults have been predominantly driven by media. This sector is broad and diverse, and while certain companies are benefiting from ratings tailwinds due to new and emerging technologies, those associated with legacy media have been suffering from weakening operating metrics. Legacy media is in secular decline as related mediums are increasingly displaced by streaming and other digital content. Amid their attempts to adapt, these companies also have also had to contend with right-sizing their balance sheets. The elevated interest rate environment has been most challenging for lower-rated issuers. Given that a little over 85% of the media portfolio is in speculative-grade territory, media sector has been disproportionately impacted by negative rating outcomes.

Related Research

• When Is A Restructuring Viewed As A Selective Default?, Oct. 15, 2024
• A Rise In Selective Defaults Presents A Slippery Slope, June 26, 2023