S&P warns on credit risk over recaps

The level of debt being placed on private equity-backed companies through recapitalisations could undermine their credit ratings, says a new report.

Standard & Poor’s, a ratings agency, has warned that the private equity industry could undermine the credit quality of portfolio companies through the excessive use of recapitalisations in order to boost returns and recoup initial investment costs.

According to Standard & Poor’s, there were 63 bank loan recapitalisations totaling $24.1 billion (€18.9 billion) in bank debt in the first five months of 2006, compared to bond issues totaling $1.3 billion in the same period.

While the number of default rates connected to private equity-backed recapitalisations are low, “many companies that have undertaken them are labouring under debt burdens that have eroded their creditworthiness”, said Standard & Poor’s in a report entitled The Dividend Recap Game: Credit Risk vs. The Allure of Quick Money.

The report highlights the example of Hertz, a US car rental company acquired in a $14 billion leveraged buyout by Clayton, Dubilier & Rice, The Carlyle Group and Merrill Lynch Private Equity in December 2005. The private equity firms committed $2.3 billion of equity, almost half of which they managed to recoup six months later through a $1 billion recapitalisation.

The report said that the transaction was likely to weaken Hertz’s credit profile, although it added “we haven’t yet determined to what extent, and we haven’t yet revised its rating”.

In April, the ratings agency warned European lenders to take full account of recovery prospects when committing to leveraged loans, adding that there had been “clear signs” that credit discipline in the European leveraged finance market was being undermined in the scramble for assets.