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Moody’s highlights financial engineering in buyouts

Large US buyout firms cash out the majority of their equity in a third of deals before they fully exit, but default rates across large private equity companies remain minimal.

Rating agency Moody’s has shown large private equity firms removed all or nearly all of the initial equity committed in 30 percent of deals. In 10 percent of deals firms took a dividend of more than 80 percent of their equity within a year.

Even the worst firms don’t (take out dividends) on every transaction. But there are no choir boys here. The difference is are they really aggressive or are they less aggressive.

John Rogers, Moody's

Moody’s factors into its rating of some transactions the possibility of a financial sponsor increasing leverage at a company.

Moody’s said while judging each deal on its own merits, “the possibility of future dividends” was particularly relevant if a company’s operating fundamentals and initial balance sheet was weak compared with similarly rated peers.

Recapitalisations have also substantially decreased since the onset of credit market difficulties. In the fourth quarter of 2007 leveraged buyout volume accounted for 86 percent of financial sponsor loans as opposed to 47 percent in the fourth quarter of 2006, when recapitalisations were far more common, according to data provider Dealogic.

John Rogers, a senior vice president at Moody’s Investors Service, said: “When money was cheap these firms did a lot of things. It will be interesting to see which private equity firms support their businesses when the companies run into difficulties,” Rogers said.

In 50 of the 176 transaction rated by the agency between 2002 and September 2006 private equity firms took out more than 80 percent of the equity used in an initial transaction. Cerberus did this in 57 percent of deals, Blackstone in 40 percent and TH Lee in 38 percent. Providence Equity Partners and Kohlberg Kravis Roberts only did this in around 10 percent of deals.

In more than a third of deals US buyout firms Thomas H Lee Partners and Apollo Management took out dividends from companies within the first year of taking a company private.

Rogers said: “Even the worst firms don’t (take out dividends) on every transaction. But there are no choir boys here. The difference is are they really aggressive or are they less aggressive.”

Despite such wide-ranging use of financial engineering by financial sponsors in the US only two of the companies in the Moody’s study defaulted compared with a 3.4 percent high yield default rate in the US market.

Private equity firms attract better managers, are intelligent and may be better financial stewards but it will also be difficult to assess this “until two years down the road” Rogers said.