JUDGING THE VINTAGE

Mark Wolfson, co-founder of Oak Hill Investment Management, says concerns about investments made in 2006 and 2007 are overdone. It's a heartening assessment, if a little surprising given the recent allusion in a Financial Times article to private equity “zombie companies” bought in highly leveraged deals just before the credit crunch and now judged to be worth less than they owe to creditors.

The truth is, it's too early to form a definitive judgement about the 2006/07 vintage just yet. Some interesting insights are nonetheless provided by a recent survey from Standard & Poor's which examined the performance of a sample of European leveraged loans, composed primarily of loans backing private equity buyouts. The ratings agency says the results are indicative of leveraged deals syndicated at the top of the market, with 44 percent of them having occurred in the first half of 2007 (when debt to EBITDA ratios topped out at an average of 6.6x) and 39 percent in 2006 (5.4x).

Overall, the picture is worrying. S&P found that 53 percent of companies in the sample were behind their original EBITDA forecasts while 47 percent were outperforming original forecasts. Meanwhile, precisely half were matching or beating de-leveraging targets, with the other half having more debt on their balance sheets than originally planned. Glass half-full or half-empty? Take your pick.

However, what S&P refers to as the “variance of the data” is much more informative. In terms of EBITDA underperformance/overperformance, the sample had a fairly high standard deviation of 22 percent. But when it came to de-leveraging, the standard deviation was a whopping 46 percent – in other words, while some companies are well ahead of target when it comes to paying down debt, others are lagging way behind, and at significant risk of covenant breach or default.

But what of the widely held belief that covenant-lite deals have bought portfolio companies a lot more time before the prospect of a covenant breach rears its ugly head? The S&P survey reveals this to be only partially true. Overall, covenant headroom for debt to EBITDA did indeed climb to an average high of 26.5 percent in 2007 (the higher the covenant headroom, the more time companies have before they would otherwise breach covenants).

However, the devil is once more in the details. While median headroom for cash flow-type covenants was 68 percent, for leverage covenants the figure was just 25 percent. Furthermore, leverage covenants had a standard deviation of just 19 percent – meaning that portfolio companies are much more in danger of breaching these type of covenants than others. Some 21 percent of companies in the S&P survey had headroom of less than 10 percent on leverage covenants.

Prima facie, retail companies appear most in danger of leverage covenant breaches, with median headroom at a slender 15 percent. But while retailers are revealed to have the worst EBITDA performance at a median of 20 percent behind forecast, such companies are performing close to forecast on de-leveraging – which the survey suggests may be due to efficient cash conversion of generated EBITDA.

The sector apparently in worst shape in the S&P sample turns out to be industrial equipment, with companies 12 percent over debt projections and 8 percent behind EBITDA projections. Publishing companies were slightly ahead of EBITDA forecasts and missing de-leveraging forecasts by 1 percent, while best placed were chemicals companies (5 percent ahead of both EBITDA and de-leveraging targets). However, while chemicals companies benefitted from “the prolonged petrochemical up-cycle” through 2007, the survey points out that the prospect of US recession poses a major threat to them in the period ahead.

The survey also reveals that, while 2006-07 leveraged buyouts as a whole are approximately in line with EBITDA forecasts and debt repayments at the current time, secondary buyouts within the sample are 9 percent behind EBITDA projections while saddled with 3 percent more debt than forecast.

On the whole, the S&P findings may give no great cause for alarm. But this is in danger of missing the point. After all, it is clear that some types of investment are much more at risk than others. What's in your portfolio?