Even after undertaking extensive efforts to manage portfolio company liabilities, some sponsors will still see businesses fail; they will need to help their favored investments survive as the credit cycle turns against overextended borrowers in their portfolios.
PitchBook data shows at least 18 PE-backed companies filed for bankruptcy in the US during the first five months of 2023—the highest number since 2020. The rise coincides with an overall uptick in US corporate bankruptcies.
The companies include some prominent names like KKR-owned hospital staffing company Envision Healthcare, Advent International-backed mattress-maker Serta Simmons, and Vice Media, a once red-hot media giant that counted TPG and Sixth Street among its backers.
Several of these distressed borrowers listed more than $500 million in total liabilities when they filed for bankruptcy. Envision listed $7.7 billion in outstanding debt.
New names have also found their way onto the growing list. Aircraft parts distributor Incora, a portfolio company of Platinum Equity, filed for Chapter 11 bankruptcy protection this month to restructure $3.14 billion in debt. And GenesisCare, a Sydney-headquartered healthcare provider backed by KKR, recently entered bankruptcy with more than $1.7 billion in debt.
A mix of adverse conditions created a perfect storm that trampled the balance sheets of over-leveraged companies that are no longer able to service their debt, said Daniel Ehrmann, the head of restructuring at King Street Capital Management, a hedge fund manager that specializes in trading distressed assets.
More sponsor-backed companies are cracking under the strain of a spike in corporate borrowing costs due to the increase in interest rates—from nearly zero in March 2022 to a range of 5% to 5.25% in May 2023—persistent inflation pressures, and lingering supply disruptions, Ehrmann added.
Meanwhile, lenders, in particular banks, are tightening their belts and becoming more stingy with credit, leaving many companies that might otherwise be qualified for additional borrowings to face heightened scrutiny.
“Banks are all terrified,” said Michael Sweet, a partner at Fox Rothschild. “What happened with Silicon Valley Bank, Signature Bank and First Republic created a shudder through the financial markets in the United States.”
Debt maneuvers serve as a Band-Aid
Several of the 18 companies implemented aggressive out-of-court restructurings in the last two years to manage their liabilities before eventually seeking bankruptcy protection. In a so-called “drop-down” transaction last year, Envision Healthcare moved valuable assets out of reach of existing lenders and used the transferred assets as collateral for a new loan, PitchBook LCD reported.
Shortly after that deal, Envision facilitated another debt exchange, through which it convinced a subset of existing lenders to permit the issuance of a new superpriority debt, which will leapfrog other creditors in the event of a default.
Serta Simmons and Incora executed similar practices in a bid to stave off bankruptcy. Companies typically try to take advantage of covenant loopholes in existing credit documents to secure fresh financing, but not all of them can survive, even with temporary liquidity support.
Financially stressed companies with PE owners tend to manage their debt burden through these out-of-court restructurings in hopes of preserving ownership rather than giving up control to creditors. As defaults among portfolio companies tick higher, however, the risk of losing ownership in these companies has become a pain point for many PE firms.
“It shows that oftentimes these liability management exercises are not a fix,” said Ehrmann with King Street. “They’re just a temporary plaster. And I think that does not bode well for private equity firms.”
It’s worth noting that private equity-backed companies only accounted for 22.5% of total US corporate bankruptcies through the end of May—a considerably lower percentage than that of 2020 and the two years leading up to the pandemic.
Loans of PE-backed companies also posted a lower default rate than those issued by companies without PE backing.
According to PitchBook LCD, the trailing twelve-month default rate of PE-backed loans stood at 1.07% through May 31, versus 2.42% for non-sponsor-backed companies. The data, however, does not take into account distressed debt exchanges.
The tip of the iceberg
PE firms are equipped with ample dry powder to support their portfolio companies. However, as the market downturn persists, they are becoming more selective about which of their portfolio companies to back, pumping liquidity only into their most promising businesses.
“The $200 million investment … provides Travelport with significant liquidity while demonstrating investors’ strong belief in the company’s bright future,” the company said in the announcement.
“Early on in the cycle, when you don’t even know how long a downturn or a recession will last, companies are doing liability management transactions, and trying to figure out ways to extend [runway],” said Jason Friedman, global head of business development at Marathon Asset Management.
Industry experts think the default cycle in the US leveraged finance market is only in its early innings. Deutsche Bank analysts estimated default rates for US loans could peak at 11.3% by the fourth quarter of 2024, suggesting more cash-strapped companies will default on their debt, according to a May 31 note.
“It’s a question of triage, which means that if you have a couple of portfolio companies with these issues, it’s manageable,” Ehrmann said. Should these sponsors find themselves with too many problematic assets, they will need to resort to secondary sales of portfolio companies, he added.
“We have the saying ‘the worst go first,’ … this is just the tip of the iceberg, and we are going to see much more of that.”
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