LBO companies often have fragile balance sheets that leave them teetering on the brink of bankruptcy and at the whims of turbulent financial markets.
“The more debt a company has, the more likely it is to default on that debt,” said David Silverman, senior director in corporates at Fitch Ratings.
The LBO model can work well — especially for private-equity firms — during booms. Boosted by an influx of cash, the newly private companies are revitalized and flipped in IPOs or strategic sales. But these deals can blow up in spectacular fashion when markets and economies crash.
“Private-equity backed LBOs are the most vulnerable to any kind of economic downturn, whether it’s a pandemic or traditional recession,” said Chris Padgett, head of the leveraged finance practice at Moody’s Investors Service. “Their intent is to use a lot of debt. That is part of their business model.”
‘Fragile balance sheets’
It’s not just the debt that makes LBOs risky.
Private-equity firms cut costs — sometimes drastically through aggressive layoffs — to make the companies look more attractive in a future IPO or sale. And private-equity firms often pay themselves dividends and fees — sometimes by forcing the companies they take over to borrow further.
Dennis Kelleher, CEO of Better Markets, slammed what he called the “predatory private equity business model” of firing workers and unloading pension obligations.
“Once a private equity firm extracts the maximum amount of value it then tries to flip it into the public markets so it can cash out on the near-carcass of a corporation,” Kelleher said.
Last month, Moody’s warned that the weak credit ratings of companies owned by private-equity firms suggests an “elevated default risk.” A stunning 80% of companies with risky companies with a B3 rating are private-equity backed LBOs, the credit ratings firm said.
“The proliferation of lower-rated, PE-owned companies with high leverage, small scale, niche business models, and fragile balance sheets may exacerbate this default cycle,” Moody’s said.
From LBO to Chapter 11
The pandemic has caused a spike in bankruptcies from a wide spectrum of companies, including some that are owned by private-equity firms.
Still, David Yermack, a professor at NYU Stern School of Business, argued the Hertz bankruptcy had little to do with its previous private equity ownership.
“It was inevitable that a firm like Hertz, which had grossly over-expanded, would have needed to restructure itself,” Yermack said. “The rental car industry needed to shrink.”
J.Crew goes bankrupt. Abercrombie is hanging on
Abercrombie “generates more cash because it isn’t getting siphoned off to pay interest expenses,” said Fitch’s Silverman. “It can reinvest in the business. And management time and attention aren’t focused on capital structure concerns.”
The fact that J.Crew was banking on the Madewell IPO made it vulnerable to the market turbulence that erupted during the pandemic. Not only did the IPO markets shutter, but companies with junk bond ratings were briefly shut out of the capital markets.
LBOs are a ‘common factor’ for distressed retailers
None of this is to say that LBOs are the sole reason these companies filed for bankruptcy. They all operated in challenged industries made more challenging by the pandemic.
For example, mall-based retailers were already struggling because of the surge of online shopping and rise of fast fashion brands. The coronavirus crisis has only exacerbated the shift to e-commerce and death of malls.
“These firms are often occupying real estate that could be put to better uses than retail sales, and when they go bankrupt, the real estate is freed up for redevelopment,” said NYU’s Yermack. “Not to allow these firms to fail would simply slow down a process that will have long-term benefits for the economy by repurposing assets and creating different types of jobs.”
Still, there is a long history of LBO bankruptcies in the retail industry.
In February 2018, Fitch put out a report that argued LBOs are a “common factor for many distressed retailers.” Although the capital structures “appeared sustainable” at the time of the LBOs, weakening cash flow and mis-execution made it hard to repay those “heavy debt burdens,” the Fitch report said.
PE firms are major employers
Last year, Senator Elizabeth Warren introduced legislation that would close loopholes she says allowed private-equity firms to capitalize on their investments while passing risk on to target companies, shareholders, employees and customers.
“Private equity can often be the only source of support for businesses struggling during a recession or economic crisis,” the ACI said. “Public investments often dry up in a bear market, while banks and other providers of credit are hesitant to invest in companies that may not survive.”
The next dominoes to fall
The recent LBO bankruptcies could just be the tip of the iceberg.
Even some very recent LBOs are suddenly teetering.
The Envision troubles underscore one the central challenge facing LBOs today. The decade-long bull market in stocks caused private-equity firms to pay top-dollar for some takeovers. Those lofty purchase prices in turn amplified the leverage.
“They can’t sit on cash forever,” said Padgett, the Moody’s analyst. “If you paid a very high multiple and then you end up with an asset that’s not performing — and then you go into a pandemic, it’s a lot to absorb.”
In other words, more LBO bankruptcies are coming.