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Leveraged Buyouts

Lessons from 200 LBO Defaults

2 3 3 5 7 7 9

Investor recoveries from LBO defaults are in line with those from non-LBOs

Table of Contents:
LBO RECOVERIES IN DEFAULT MATCH UP WITH NON-LBOS LBO RECOVERIES PERFORM THROUGH DEFAULT CYCLES CHOICE OF DEFAULT TYPE IS A KEY DRIVER OF LBO RECOVERIES ASSET-HEAVY INDUSTRIES DONT RECOVER MORE MEDIA LBO UPS AND DOWNS FIGHTING TO AVOID LIQUIDATION MOODYS RELATED RESEARCH

LBOs do not worsen investor recoveries. The high leverage of LBOs has not translated into lower returns to lenders in the event of default. Our review of 200 LBO defaults dating back to 1988 finds an average family recovery rate of 54%, almost identical to the 55% average rate for more than 800 non-LBOs. Default type is a key factor. LBOs defaulted via distressed exchanges and prepackaged bankruptcies more often than non-LBOs. These default types generally produce higher investor recoveries than regular bankruptcies or liquidations. Less than half of LBO defaults in our database occurred through regular bankruptcy filings (not prepackaged), compared with nearly two-thirds of non-LBO defaults. Bank debt recovers less in LBOs. Although family recoveries in LBO defaults are on par with non-LBOs, the LBO bank debt recovers less because it has a smaller cushion of subordinated debt. Without the use of distressed exchanges in which the bank debt is usually allocated a 100% recovery bank debt recoveries would have been even lower. Asset intensity not a major factor. Average recoveries are very similar for LBOs and non-LBOs in both asset heavy industries like manufacturing and asset light industries like technology. This contradicts the view that asset-heavy companies yield better investor recoveries because they have more assets available to creditors. The likely reason is that lenders incorporate a companys asset characteristics in lending decisions. LBOs avoid liquidation. LBO companies have been much less likely to liquidate than non-LBOs, reflecting LBO sponsors preference for distressed exchanges and prepackaged bankruptcies, as well as their interest in preserving relationships with banks.

Analyst Contacts:
NEW YORK +1.212.553.1653

David Keisman +1.212.553.1487 Senior Vice President david.keisman@moodys.com Randy Lampert +1.212.553.2932 Associate Analyst randy.lampert@moodys.com Tom Marshella +1.212.553.4668 Managing Director - US and Americas Corporate Finance tom.marshella@moodys.com

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LBO recoveries in default match up with non-LBOs

Most research on the topic of leveraged buyouts has focused on the effects of LBOs and on the probability of LBO defaults. Relatively little has been written about investor recoveries when LBOs default. In this report, we find that the high leverage of LBOs has not translated into lower recoveries for investors in the event of default. While the LBO sponsors could not spare these companies from defaulting and may have prompted defaults through high leverage the average family-level recovery rate in these situations was nearly the same as the average rate at defaulted companies that had not experienced an LBO. LBOs accounted for about half of defaults during the Great Recession, and about half of the population of companies rated B3 negative or lower at the time. Of the more than 1,000 defaults in Moodys Ultimate Recovery Database, about 200 occurred at companies that had undergone leveraged buyouts. The average family recovery in these LBO defaults was 54%, compared with 55% at non-LBO companies (Fig. 1). This suggests that whether or not the defaulter was an LBO had little effect on recoveries. 1 To be sure, there are many other factors that can affect recovery rates, such as company size, industry mix and default timing. But sorting the 1,000plus defaults in our database solely on the dimension of LBO transactions suggests that LBOs alone do not lead to materially lower recoveries for lenders to sponsored companies.2 The 201 LBOs in our sample had an average of $871 million of defaulted debt, matching the average for the 805 non-LBO defaulters. The median defaulted debt amount was $407 million for the LBOs and $272 million for the non-LBOs. These data are drawn from Moodys Ultimate Recovery Database, which tracks recovery rates for more than 1,000 defaults dating back to 1988. In terms of ratings of sponsored companies, we have done previous research3 indicating that we have on average assigned ratings appropriately after private equity takeovers. The research has indicated that default rates at each rating level were similar for sponsored and non-sponsored companies.
FIGURE 1

Average Recovery Rates

LBO Count* Non-LBO Count*

Family Recovery Bank Debt Senior Secured Bonds Senior Unsecured Bonds Subordinated Bonds
*Unique Tranches of Debt

54.13% 74.96% 66.38% 37.39% 24.16%

201 251 49 86 165

54.52% 83.26% 66.46% 40.70% 30.40%

805 766 211 383 537

This echoes the findings of our previous LBO research report, Cheating Death: Private Equity Manages Solid Recoveries When Sponsored Companies Default, which was based on a much smaller data set. The LBOs in our sample include traditional LBOs by large private equity firms, as well as management buyouts, acquisitions by individuals and smaller equity firms and other structures. Default and Migration Rates for Private-Equity Sponsored Issuers, November 2006

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LBO recoveries perform through default cycles

A look at the last three default cycles further demonstrates that LBOs do not exhibit unusual recovery characteristics. The bar chart (Fig. 2) shows the three separate cycles in which default rates have exceeded the historical average. During the three default cycles, average family recoveries were similar for both LBOs and non-LBO companies, mostly in the low-50% range, further support for the view that LBOs are not inherently disadvantaged in terms of recoveries. In most cases, average family recoveries were slightly lower for LBOs; the one time that was not the case was in the 1999-2004 default cycle, in which non-LBO defaults had lower average family recoveries because they included some large telecommunications startups that had very poor recoveries.
FIGURE 2

Number of Defaults by Year

Non-LBO 120 100 80 60 40 20 0 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 LBO

Source: Moodys Ultimate Recovery Database

Choice of default type is a key driver of LBO recoveries

One way that LBOs have achieved this relative parity of recoveries with non-LBOs is through the high proportion of distressed exchanges and prepackaged bankruptcies among defaulting LBOs. As shown in Fig. 3 on the following page, less than half of LBO defaults were regular bankruptcies (not prepackaged), relative to the nearly two thirds of non-LBOs that defaulted via bankruptcy. For senior creditors, a prepackaged bankruptcy or distressed exchange typically yields higher recovery rates than does regular bankruptcy because only the junior debt typically suffers losses. This is the case because companies experiencing distressed exchanges and prepackaged bankruptcies are usually less distressed, with higher enterprise values, than companies experiencing regular bankruptcies. Further, distressed exchanges are a common way that equity sponsors will initiate a default so as to maximize the ownership position they retain in the sponsored company. There are a few more things to note about distressed exchanges. First, distressed exchanges may be followed by additional distressed exchanges or an eventual bankruptcy filing if the company remains under credit stress. Second, our database captures each of these instances of default and counts it separately. Finally, for purposes of this analysis, our family recovery calculations for distressed exchanges included an allocation of full recovery for the debt instruments that did not default. Therefore, family recovery rates were typically high in the distressed exchanges, even as the defaulted debt that was subject to the exchange incurred larger losses.

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FIGURE 3

LBO and Non-LBO Defaults by Default Type

LBO Non-LBO

Regular Bankruptcy Prepackaged Bankruptcy Distressed Exchange

Source: Moodys Ultimate Recovery Database

47% 35% 19%

63% 20% 17%

The recovery data in Fig. 4 show that distressed exchanges produced the highest average recoveries in each of the last three default cycles, while regular bankruptcies consistently produced smaller average family recoveries compared with the other types of default.
FIGURE 4

Family Recoveries by Default Type

LBO 12/31/1989 12/31/1992 9/30/1999 2/29/2004 1/31/2009 8/31/2010 Outside the Three Cycles

Regular Bankruptcy Prepackaged Bankruptcy Distressed Exchange

46.90% 54.30% 72.05%

38.23% 61.25% 78.29%

44.05% 63.69% 69.64%

48.65% 49.61% 75.85%

48.08% 54.32% 73.10%

Non-LBO

12/31/1989 12/31/1992

9/30/1999 2/29/2004

1/31/2009 8/31/2010

Outside the Three Cycles

Regular Bankruptcy Prepackaged Bankruptcy Distressed Exchange

50.10% 53.18% 71.75%

45.12% 59.38% 79.49%

46.99% 48.42% 67.84%

57.09% 53.69% 86.30%

54.54% 57.20% 74.07%

Source: Moodys Ultimate Recovery Database

The performance of distressed exchanges reflects their limited scope, with non-defaulting instruments receiving an allocation of 100% recovery. The non-defaulting instruments include the bank debt at the top of the capital structure. The fact that this non-defaulting debt does not incur losses in distressed exchanges raises average recoveries for all bank debt (Fig. 1). Nevertheless, bank debt recovers less in LBO defaults than in non-LBO defaults. This is explained by the smaller cushion of subordinate debt among the LBOs in our database than the non-LBOs (Fig. 5). In turn, the subordinated LBO debt has lower recoveries than those tranches in non-LBOs because the preponderance of bank debt in LBOs leaves less value for junior creditors, which must bear losses first.

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FIGURE 5

Cushion Under Bank Debt

LBO Non-LBO

Average Cushion Median Cushion

Source: Moodys Ultimate Recovery Database Note: The cushion is the percentage of the dollar value of total debt represented by subordinated tranches.

44.99% 44.21%

50.46% 56.09%

This smaller debt cushion under bank debt might also help motivate distressed exchanges. Although sponsors have strategic incentives for distressed exchanges, they may also pursue an early default via distressed exchange when a company comes under stress in order to leave the bank debt untouched in default. LBO sponsors need to preserve positive relationships with banks in order to maintain access to future deal funding. This might also motivate prepackaged bankruptcies, which produce higher recoveries for bank debt than do regular bankruptcies.

Asset-heavy industries dont recover more

A look at the data by industry shows that average family recoveries are very similar for asset-heavy and asset-light industries in both LBO and non-LBO defaults (Fig. 6, next page). There is a view that asset-heavy companies yield better investor recoveries than asset-light companies because they have more assets available to creditors in liquidation, but the recovery data do not bear this out. The likely reason is that lenders incorporate a companys asset characteristics in their lending decisions, with asset-light companies constrained to lower debt levels relative to asset-heavy companies. While Moodys does not formally delineate asset heavy and asset light, we produced the breakdown on the following page for purposes of this analysis. As shown in Fig. 6 , media, manufacturing, consumer products and distribution accounted for nearly two-thirds of the defaulted LBOs.

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FIGURE 6

Asset-Heavy Industries Do Not Recover More

Average Family-Level Recoveries LBO Non-LBO

Asset Heavy Asset Light

56.28% 52.76%

54.58% 54.62%

Default Counts LBO Asset Heavy AIRCRAFT & AEROSPACE AUTOMOTIVE CHEMICALS CONSTRUCTION DEFENSE ENERGY ENVIRONMENT INDUSTRIALS MANUFACTURING METALS & MINING NATURAL PRODUCTS TELECOMMUNICATIONS TRANSPORTATION Asset Light CONSUMER PRODUCTS DISTRIBUTION HOLDING COMPANY LEISURE & ENTERTAINMENT MEDIA PACKAGING SERVICES TECHNOLOGY
Source: Moodys Ultimate Recovery Database

Non-LBO 0 28 15 16 1 79 7 12 75 35 12 69 27 79 90 3 63 44 5 71 40

1 13 5 3 1 4 1 8 29 3 4 5 6 32 33 0 8 26 3 5 3

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Media LBO Ups and Downs

By John Puchalla, Vice President-Senior Credit Officer Private equity targeted the media industry because media companies typically had high margins and good cash flow generation. But most media companies generate the bulk of their revenue from highly cyclical advertising revenue. On top of that, certain sectors within media are struggling with technology-driven competitive changes that are creating significant revenue pressure. This combination proved lethal for highly leveraged borrowers particularly in the severe consumer-led downturn of 2008-2009.

Advertising is a high-margin business with high operating leverage leading to strong earnings growth when revenues are rising. Thus, returns to private equity owners can be outsized when the economy continues to grow following a media LBO. However, there is a downside. Advertising is tied to GDP and companies usually cut back their investment in advertising when they sense it is not driving consumers to buy their products and services. It is also an easy expense to cut in a downturn as it can limit the need for layoffs. Consumer-led downturns make matters worse. They are generally deeper and longer than other recessions and are particularly harmful to advertising-driven businesses. Other sub-sectors were also hit hard such as trade show operators when corporate travel and entertainment spending was whacked in the downturn. Advertising was on a good run coming out of the 2001 recession with spending growing by 4.4% annually from 2002 to 2006, according to Magna Global. Unfortunately, this prompted many private equity firms to LBO media companies at very high multiples funded with significant leverage. We believe adequate stress-testing was lacking as many used the rather mild 2001 recession (when advertising dropped 5.1%) to build their downside cases. The problem is that the 2001 downturn was driven more by a bursting of the internet bubble and September 11th terrorist attack fall-out while consumer spending remained relatively healthy. As a result, the 2001 recession was a poor proxy for what could happen to advertising in a consumer-led downturn. Many individuals in private equity driving the media LBO boom were not around at the time of the previous consumer-led recession in the early 1990s or they did not believe it would be repeated. Many media LBOs thus did not have the liquidity to manage through the Great Recession as advertising dropped 5.5% in 2008 and another 16.2% in 2009 (according to Magna Global). Printfocused businesses fared even worse as the shift in advertising to online and digital channels hit them particularly hard. The result was a wave of restructurings. Eighteen of the 26 media LBOs in the ultimate recovery data set defaulted from 2007-2010. This compares with just two in the aftermath of the 2001 recession.

Fighting to avoid liquidation

Our final observation about LBO defaults is that they go into liquidation at a lower rate than nonLBOs. This reflects sponsors tendency to buy existing companies with quantifiable cash flow histories. About 9% of the LBO defaults in our database ultimately liquidated and 19% of the LBOs that filed for regular bankruptcy ended up in liquidation (Fig. 7). The corresponding figures are 18% and 28% for non-LBOs, which suggests that in addition to attempting to manage recovery outcomes by a

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preference for prepackaged bankruptcies and distressed exchanges, LBO sponsors also tend to avoid liquidations. LBOs liquidate at a significantly lower rate than non-LBOs even in regular bankruptcies. This seems counterintuitive because one might generalize that the less than half of defaulted LBOs that go into regular bankruptcy are of lower quality, given creditors preference for prepackaged bankruptcies and distressed exchanges, and, therefore, would be more likely to liquidate. Nonetheless, a much higher percentage of bankrupt LBOs were acquired or emerged from bankruptcy instead of being liquidated.
FIGURE 7

Liquidations as a Percentage of Defaults

LBO Non-LBO

Regular Bankruptcy All Default Types

Source: Moodys Ultimate Recovery Database

19.12% 8.96%

27.93% 17.64%

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Moodys Related Research

Special Comments: Cheating Death: Private Equity Manages Solid Recoveries When Sponsored Companies Default, November 2010 (128561)

$640 Billion & 640 Days Later: How Companies Sponsored by Big Private Equity Have Performed During the U.S. Recession, November 2009 (121005) Private Equity 2009: Nearly Half of Defaults, But Better-Than-Average Recovery Prospects, March 2010 (123914) The Private Equity Advantage: Sponsored Issuers in the Credit Crunch, December 2008 (113270) Default and Migration Rates for Private Equity-Sponsored Issuers, November 2006 (100799)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

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Report Number: 142361

Author David Keisman

Production Specialist Wing Chan

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