Credit crunch to wipe out sponsor equity

The ongoing deterioration of the worldwide credit markets has led to the prospect of some private equity-owned companies becoming worth less than the value owed to creditors.

The deterioration of the credit markets has considerably worsened in the last month and has raised the prospect of the debt markets not recovering fully for another two years.

Ed Eyerman, head of European leveraged finance research at rating agency Fitch, said: “Sponsors are likely to be stuck with their companies for at least two years.“ The disappearance of liquidity in the debt markets is likely to take this length of time ruling out refinancings in the majority of cases. The decline in comparable equity valuations also meant that companies would not be able to exit, he said.

This has led to worries that companies could become “zombies” as they become worth less than the money owed to creditors valuing their equity at zero, according to Fitch.

“Zombies can continue making interest payments and be compliant, but they don’t have a viable exit option. But sponsors rightly point out these are thin markets and they are not forced sellers in any way,” Eyerman said. He said many of the credits that are trading on the debt markets at distressed levels are also covenant lite loans and so financial sponsors can hold portfolio companies for longer.

If companies’ performance deteriorates the zombie scenario will become more likely. “[Buyout firms] have given themselves aggressive revenue and cashflow assumptions to meet. They have time on the side if they perform but they’ve got to earn their equity portion back.”

He said 40 percent of 300 plus ratings in Fitch’s private rating portfolio corresponding to European private equity debt-owned by private managers such as CLOs are rated at B-. He said these companies are “performing, but vulnerable.” He declined to comment on which companies are potential zombies.

While Fitch has a troubled outlook for European credits, across the Atlantic the credit markets have reached the highest level of distress in nearly five years. The ratio of distressed credits trading in the US debt markets rose to its highest level since April 2003, according to rating agency Standard and Poor’s.

The rating agency’s distress ratio increased by more than 5 percent to 22.2 percent in March up from 0.8 percent the same time last year.

S&P said: “A rising distress ratio signals an increased need for capital and could act as a precursor to more defaults if accompanied by a market disruption.”

The agency said the rise in the distress ratio was largely attributable to more than $39.5 billion (€25.1 billion) of senior unsecured debt issued by Cerberus-owned finance company GMAC and finance company Ford Motor Credit Company. The two companies have a combined 32 issues of debt trading at distressed levels.

While the increase in distressed levels relates to all speculative grade issues, the number of these credits in a distressed situation are predominately private equity-backed. In a separate report published last week S&P said there are 114 companies with weakest link credits (those closest to default) globally of which 93 are US-based. In the US more than half these companies were private equity-owned. 

Notable private equity-owned distressed credits, which S&P believes also have a negative credit outlook, include electronic payments company First Data and Freescale Semiconductor.