Trouble Brewing

Just like their counterparts in the investment banking universe, private equity firms in both the large and middle markets are also feeling heat from the economic downturn. Portfolio companies owned by buyout firms of all sizes are facing the possibility of restructuring or bankruptcy.

"It's no surprise that in times like these private equity firms that were bullish in the past might run into some issues with portfolio companies," says John Jonge Poerink, managing partner of middle-market private equity firm LJH Linley Capital.

"Middle-market portfolio companies are not totally dissimilar to larger private equity deals that have been done," says Charles Weissman, co-chair of the business restructuring and reorganization group at Dechert. "Two years ago, many of these companies took on a lot of debt and are now overleveraged, and that's because lending institutions were going easier on credit. Even in the middle market, there were covenant-light loans, and many companies that went the private equity route two or three years ago will probably have covenant problems this year."

Most deals done in the middle market included more than one level of debt-senior term A and B, mezzanine and/or second-lien, adds Weissman.

Last week, Jon Moulton, managing partner of London-based mid-market private equity advisory firm Alchemy Partners, made headlines by telling attendees at the London Stock Exchange Alternative Investments Conference that he would not be surprised if 30% of middle-market private equity portfolio companies failed during the recession. Moulton told IDD, a sister publication to MAR, his analysis only applies to European companies.

However, in the US and other markets, it is difficult to determine exactly how many private equity portfolio companies-both large- and middle-market-are distressed. "Private equity firms are privately-held investment firms with limited partners that invest predominantly in private companies, so other than reporting to their limited partners, this type of information is typically kept confidential among the general partners and investors," says Poerink. "But, portfolio companies are certainly affected by this tough, unprecedented macroeconomic climate."

Of course, not all troubled portfolio companies necessarily have to file for bankruptcy protection. "The question is what 'failure' means," says Mark Bane, co-head of the bankruptcy and business restructuring group at Ropes & Gray. "People are focusing on whether there is going to be an onslaught of bankruptcies, or whether companies that need tinkering will be able to implement recapitalizations or capital structure adjustments without having to resort to Chapter 11. You see liquidations in the retail space, but no heightened liquidations or threats in any other space."

Many companies are benefiting from payment-in-kind toggle or covenant-light loans which, in earlier eras, would have triggered bankruptcies or more expedited restructurings.

"It's a race against time as to which will happen first-the expiration of covenant-light loans or the end of the recession," says Bane. "There are a lot of companies in that situation now. They're hoping the market turns around quick enough that they can avoid hitting the ground."

Bane says his practice is working with many small US companies from various sectors, including automotive supply, retail, computers and consulting. If the recession lasts for two or three years, there will inevitably be more companies pursuing some degree of restructuring, but many troubled entities will avoid having to do so if the economy turns around this year.

"Besides the issue of market performance, a significant challenge is presented by deals in which debt is coming due in the short term in a credit market where you can't find anyone to refinance them," says Bane. "If they have bond debts in place for three to four years they could be optimistic that the market could open up before then, but if they're coming due in 2009, they're concerned."

Debt absolutely trumps individual performance. "A maturity is a maturity, even if you have a portfolio company that's performing well," says Poerink.

In response to distress among portfolio companies, private equity firms can invest on the equity side in exchange for waivers or forbearance agreements. By doing so, the firms can protect their equity investments by purchasing debt now trading at between 30 and 50 cents on the dollar. Weissman was recently involved with two different mandates in which private equity firms purchased portfolio company debt at a steep discount. In those cases, the senior lenders wanted to unload the debt from their balance sheets.

"Overleveraged companies will survive, but the question is whether they will survive inside or outside of bankruptcy," says Weissman. "If you can survive outside by either putting in more equity or buying up senior debt, you are in great shape because once you're in bankruptcy it costs a lot of money to get out."

R. Ronald Hopkinson, head of the private equity group at Cadwalader, Wickersham & Taft, who lunched with two mid-market private equity professionals prior to speaking with IDD last week (and met with others over the past three to four months), says they signaled there will be many more delayed exits in the sector.

In addition, "Even if there isn't a balloon payment on debt coming due in the short term or any other immediate crisis, there is a lot of prudent planning being done," he says. "People realize that, to the extent they can start shoring up these companies' financial picture earlier-while they're not in crisis mode-it works out better."

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