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Private Equity's Year from Hell

As the recession and financial crisis cause debt defaults and bankruptcy filings to mount, private equity investors brace for big losses and much longer waits for promised returns

The financial crisis has damaged investors great and small, and private equity funds are no exception. These funds, and the investors who plunked down millions to back their deals, appear to be facing big losses as more of the companies that they used leverage to buy—and to take cash out of —are defaulting on their debt and starting to file for bankruptcy. It's only logical that the targets of these leveraged buyouts, with their hefty debt obligations financed at junk-bond rates, are succumbing as the economic slowdown causes cash flows to dwindle and lending terms to tighten.

While private equity sponsors—the people who manage the funds that make the deals—aren't on the hook for the outstanding debt for which anxious unsecured creditors are queueing up in the hopes of being paid, the enormous opportunities sponsors had to cash out on these buyout deals have all but evaporated.

The usual paydays, from refinancings that generated big dividend payouts to initial public offerings and secondary private equity sales, have vanished. That's forced sponsors to delay cashing out of these companies by at least a couple of years and even to put more capital into some that they think have a good chance of surviving the recession.

The Model is Broken

That's a stark change from the golden age of private equity that Henry Kravis, one of the pioneers of leveraged buyouts, declared less than 18 months ago before a gathering of bankers and investors.

The entire private equity model is broken, says Brett Hellerman, chief executive of New Haven-based Wood Creek Capital Management, citing the firms' reliance on leverage that's no longer available, and on easy exits that are no longer viable. "The world's in workout right now. I don't care who you are," he says. "All these investors were expecting cash back on all their private equity investments within a three- or four-year time [frame]. That's been pushed back now, in some cases as far as the 10- to 12-year [goal] of the private equity fund. A lot of these investors are really having liquidity problems" as a result, he says.

Debt defaults are up nearly fourfold this year amid weaker economic conditions and uncertainty about the financial services industry, Diane Vazza, managing director of Standard & Poor's Global Fixed Income Research, said in a Nov. 19 report. And most of them bear the private equity stamp. Of the 86 companies around the world that have defaulted on their debt, 53, or more than 60%, were involved with private equity deals at some point. This year alone, 39 U.S. companies purchased by private equity investors through leveraged buyouts had filed for bankruptcy as of Oct. 7, according to, a Web-based public forum for the industry.

Limited Partners in Trouble

The number of recorded defaults would be even higher had banks refused to waive strict debt covenants in credit facilities they granted companies in recent years, while credit spreads were still tight and lenders worried about losing customers to their competition. Without covenants—which require borrowers to maintain certain financial ratios and profitability levels—it's harder to spot potential liquidity problems and more difficult for senior creditors to accelerate debt payments once a company gets into trouble.

The impact of the defaults and bankruptcies is potentially dire for the backers of the private equity funds, as many of them—known as limited partners—are pension funds and endowments that may now have to wait much longer than they expected to see the promised returns on their investments.

Shareholders' equity gets wiped out when publicly traded companies go into bankruptcy. But for companies controlled by private equity sponsors, the sponsors' losses are limited to their original equity, or cash, investment, which tends to be just a small fraction of the total transaction value of the leveraged buyout. In many cases, their losses have been substantially reduced by refinancing part of a portfolio company's debt and paying themselves a fat dividend.

Rich Dividend Deals

Companies acquired by private equity funds between 2003 and 2007 were particularly ripe for debt refinancings due to low interest rates and tight credit spreads—the same conditions that helped produce the subprime mortgage crisis. "Private equity sponsors often were in a position to take a lot of money off the table" through dividend deals, says Allan Brown, portfolio manager at Concordia Advisors, a hedge fund company in New York that manages $1.5 billion in assets.

The cash proceeds of refinancing debt at lower rates are paid to owners and shareholders in portfolio companies and effectively reduce the amount of capital a private equity sponsor originally contributed to a buyout of a company. A private equity fund sponsor that contributed $300 million in cash and took on $700 million in debt to pay for a company may have cut its potential loss on a company that goes into bankruptcy from $300 million to $100 million if it received $200 million in dividends from a recapitalization or sold that amount of stock back to the company.

To take one example, in 2000, private equity firms CI Capital Partners and Sentinel Capital Partners bought Buffets Holdings, a U.S. restaurant chain, in a leveraged buyout valued at $645 million, of which $130 million was the sponsors' equity contribution. Two years later, in a refinancing of debt, the company made a $150 million distribution, more than covering the sponsors' initial cash contribution, according to CI Capital's Web site. But heavily leveraged Buffets was unable to shoulder its debt burden, and filed for bankruptcy in January 2008.

No More Easy Exits

Sponsors continued to withdraw cash through refinancings on assumptions that portfolio companies would continue to generate strong cash flows that would be put toward interest payments on this debt and that the public equity market would provide easy exits, either through initial public offerings, secondary buyouts, or sales to companies in the same industry.

In trying to determine by how much private equity funds reduced their exposure to losses at a given portfolio company, the key question is how much of the money they took in dividend deals was redeployed to other deals, says Brown at Concordia.

As conditions in credit markets deteriorated and credit spreads widened between corporate bonds and U.S. Treasury notes with comparable maturities, it became harder for private equity sponsors to refinance debt and take money off the table, he says. The total dollar value of recap dividends and stock buybacks plummeted almost 93% between the second and third quarters of 2007— when the effects of the credit crisis began to be felt—from $11.47 billion to $820 million, according to Standard & Poor's Leveraged Commentary & Data.

Getting Through the Holidays

Investors in retailers and other consumer-oriented businesses are expected to be hit especially hard. Specialty retailer Linens 'N Things, which was taken private by Apollo Management, filed for a prepackaged bankruptcy under Chapter 11 in May but went into liquidation in October after not being able to find a buyer to bring it out of bankruptcy as a going concern. Jeffrey Manning, managing director of Trenwith Securities in Costa Mesa, Calif., says that if you look at the company's petition to the bankruptcy court to initiate a liquidation process, you'll see it asked to be allowed to start liquidation before Christmas so as to avoid the rush of other distressed retailers selling off their assets.

Brown says he expects to see a lot more private equity-owned retailers filing for bankruptcy after the holiday season ends, when many companies' fiscal years end. "Most retailers that are having problems desperately want to get through the holiday season because that's the season that generates the most cash for them," he says. They want to file for bankruptcy with as much cash on hand as possible to be in a better position to finance a restructuring, he says.

Diane Sterthous, director of alternative investments at Glenmede Trust in Philadelphia, Pa., says that even at the height of the recent boom, buyout deals were probably levered at six to seven times cash flow rather than the more risky 10 times cash flows of the late 1980s. Even so, "some of the deals were priced to perfection for a rosy economic scenario that's obviously not prevailing right now," she says. "If revenues start to decline, if oil prices start to rise significantly, all of a sudden the arithmetic doesn't work, the projected return doesn't work anymore."

Released from Capital Commitments

While the sponsors won't be able to cash out of their deals any time soon, investors in the funds may get a break, since she foresees the possibility that investors will be released from capital commitments which require them to keep their money in the fund for a specified period, much like what occurred after the tech bubble burst in 2000.

The managers of private equity funds are likely to realize it doesn't make sense to keep putting capital to work and "they want to do right by their clients," she says.

For the private equity funds and their backers, the best returns they can hope for in the current climate may just be a portion of their original stake.

Business Exchange related topics:

Private Equity

Financial Services Industry

U.S. Financial Crisis

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