Private-equity firms showing strain
Some of Wall Street's most private investors are beginning to have some public problems.
Private-equity firms, a revamped version of the leveraged buyout firms (LBOs) of the 1980s, are beginning to find that some of the companies they bought during the boom are showing serious signs of strain.
More than half - 25 - of the 42 companies that ratings agency Standard & Poor's says have the lowest credit ratings, and therefore the highest risk of default, are owned or controlled by private-equity firms. Many of the investments were made years ago, when it was easy to borrow money at low interest rates and buy companies.
Now, with the economy slowing and credit tight, companies are feeling the squeeze. "Some investments made by the private-equity firms are in big trouble," says Pavel Savor, finance professor at Wharton business school.
These problems have serious ramifications for investors, especially large pension plans and endowments, that invested heavily in private equity, says Bill Parish, financial adviser at Parish & Co. They can get hit twice if they invested in private-equity funds themselves and also bought bonds sold by companies backed by the private-equity firms.
Some private-equity-backed companies are now struggling because:
Big debt loads are harder to handle. Consumer spending is slowing, so companies have less cash to service the debt the private-equity firms put on them, says Kim Noland of bond-rating service Gimme Credit. "Private-equity firms were the major force behind a number of LBOs that piled too much debt onto companies," Noland says.
Leverage magnifies losses. Most private-equity firms use cheap borrowed money to amplify potential returns. But leverage accelerates the financial pain when companies they bought using debt stumble. If the value of a company falls 10.5 percent, the actual loss to the private-equity firm and its investors may be closer to 33 percent factoring in the effect of using debt, Savor says.
Companies were difficult to fix. Private-equity firms overestimated how quickly and effectively they could boost companies' performance, says Bill Larkin, a bond analyst at Cabot Money Management. If the companies "run low on cash, the game is over," he says. Plus, private-equity firms invested heavily in retailers and restaurants, two areas hit hard by the economic slowdown.
But are private-equity-backed firms worse off than other companies? Historically, debt issued by private-equity-backed companies defaults at roughly the same rate of all corporate bond issuers, says Josh Lerner, finance professor at Harvard. And Frank Guidara, CEO of Uno Restaurant, a private-equity-owned company with $142 million in low-rated debt, says the rating agencies are too negative about Uno's finances.
Still, for investors who put money in once-hot private-equity funds, "The letdown is already happening," Savor says.
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