Rating agency Moody’s has added to the chorus of critics concerned that lenders to leveraged buyouts are vulnerable in a downturn, without participating in the “upside” available to buyout firms and vendors in the current boom.
The agency said in its report that the 12 year low in 2007 of loan defaults has “led to investors showing less discrimination regarding credit quality, as evidenced by the increase in very low rated debt being issued on generous terms.”
The growing tendency of buyout firms to pay themselves substantial dividends often above their initial investments in a portfolio company despite commitments to reduce leverage. was highlighted by the agency as a cause for concern.
It cited examples such as the buyout of Warner Music by Thomas H Lee, Bain Capital and Music Capital in 2004. The three firms paid out a dividend substantially removing their equity from the company in December 2004 despite making public statements to the contrary, according to Moody’s.
“Debt that is going into businesses at the start of the acquisition is at an all time high and Moody’s chose to focus on recapitalisations which is driven by the availability of debt,” said Mark Spinner, head of private equity practice at international law firm Eversheds.
He said the industry would be relaxed at debt multiples going down because refinancing is the only way firms can make the returns they target in the present highly geared market and while banks make debt easily available, firms will take it.
“The only thing which will really dampen it would be the failure of a large company to make its repayments. This will happen but it won’t lead to the drying up of debt as in the late nineties because interest rates were in the teens then,” he added.
Moody’s also questioned the theoretical assumption that private equity companies invest over a longer term horizon than public companies because they do not need to issue quarterly reports. This is because firms often recapitalise early in the investment cycle winding down their investments.
But Moody’s did support the assumption buyout firms use of leverage was likely to improve discipline at companies and to produce higher equity returns.
Moody’s said it was difficult to measure the borrowing of companies in private equity funds affecting the quality of the ratings issued to portfolio companies. It also said underperformance by a company in a fund leads to pressure being exerted on other companies in the same fund.
The critical report comes after the debt markets have shown increasing scepticism to leveraged buyouts in the US and increasingly in Europe. According to news agency Bloomberg last week, asset managers at Fidelity and Lehman Brothers were avoiding leveraged buyout debt. BC Partners and Electra’s European heating company Baxi revealed over the weekend it was in talks with lenders to loosen the terms of its £515 million ($1 billion, €761 million) debt package to stave off a default.