A report by Moody’s Investors Services, a ratings company, has found that the additional default risk a firm takes on when a private equity sponsor acquires it varies according to its credit rating prior to being acquired.
The study looked at almost 3000 North American non-financial speculative-grade firms from the period 1987 – 2005.
Looking at the credit effects of private equity sponsorship on non-investment-grade issuers in North America, Moody’s has found that generally the amount of additional risk declines as the credit rating before sponsorship declines, and that private equity sponsorship appears to reduce default risk among distressed firms.
Moody’s shows that a debt issuer rated at the Ba-level, one category below investment grade, will, on average, double its default risk when acquired by a private equity sponsor, while an issuer in the lower B-rated category will see an increase in default risk of roughly 75 percent.
Very low-rated companies, those with Caa-C ratings, have a much lower risk of default after acquisition by a sponsor; just 10 percent compared with non-sponsored Caa-C rated companies, which have a default risk of 44.8 percent, suggesting that private equity sponsors can serve as effective “white-knights” for these distressed issuers. Moody’s notes, however, that this observation rests on a limited sample.
Moody’s says its rating actions prompted by private equity sponsorships have successfully captured these shifts in credit quality.
Moody’s vice president and senior credit officer Kenneth Emery said:“Assessing the creditworthiness of firms that have become sponsored is challenging because such acquisitions are often accompanied by changes in the firms’ financial structures, management expertise, and management incentives.”
“We find, however, that Moody’s has, on average, adjusted ratings appropriately after private equity takeovers.
“In particular, we find that default rates by rating after an issuer has become sponsored are similar to default rates for similarly-rated non-sponsored issuers,” he continued.
Moody’s also finds that recovery rates are similar for both the sponsored and non-sponsored issuers at the same rating level.
The study also shows that while the credit performance of the issuers does vary according to their sponsor, collectively the differences are not statistically significant.
The migration of ratings due to becoming sponsored follows a pattern similar to that of the changes in default risk. Issuers rated Ba a year before sponsorship are over four times as likely to see a downgrade around the time they are acquired by a sponsor as an issuer that does not become sponsored. A B-rated issuer that is sponsored, on the other hand, is only about 50 percent more likely to see a downgrade. Among Caa-rated firms, being acquired by a sponsor leads to more upgrades than downgrades, with upgrades outnumbering downgrades by over three to one.