Default and Migration Rates for Private Equity-Sponsored Issuers

Abstract

The rapid growth of leveraged buyouts over the past several years has revived debate over the impact that such transactions have on the companies acquired by private equity sponsors. From an equity return perspective, the debate usually focuses on the potential benefits and costs associated with sponsor ownership. Often-cited potential benefits include a longer term view by management, greater management and industry experience, improved efficiency, and stricter monitoring of management performance. Often-cited potential costs include a shorter-term view by management, less management and industry experience, a greater appetite for risk, and an increased focus on equity returns. From a debt investor perspective, however, while the benefits and costs of sponsor ownership cited above still apply, the consensus view seems to be that increases in leverage associated with leveraged buyouts usually increases the credit risk of existing debt and, therefore, are bad for debt holders. Certainly there are many high-profile examples of investment grade issuers being transformed into deep speculative grade issuers via leveraged buyouts. In this study, though, our focus is on speculative grade issuers where a majority of equity sponsors' capital is invested and where the impact on creditworthiness may be more ambiguous. Among speculative grade issuers, we find that issuers acquired by private equity sponsors do indeed typically experience much higher downgrade rates and default rates than other non-sponsored issuers. However, we also find significant variation in the impact on issuers' creditworthiness as a result of being acquired by a private equity sponsor. For example, we find that increases in downgrade and default risk are highest for those issuers rated Ba prior to acquisition by a private equity sponsor, while the increases in downgrade and default risk for B-rated issuers are more modest. For distressed issuers rated Caa-C prior to being acquired by a sponsor, downgrade and default risks are actually materially lower than for similarly rated non-sponsored issuers, suggesting a white-knight role for private equity sponsors. While being acquired by a private equity sponsor increases default risk and often results in downgrades for healthy speculative-grade issuers, an important issue for investors assessing the creditworthiness of such issuers is whether Moody's ratings appropriately reflect the credit effects of becoming sponsored. In other words, are actual downgrades sufficient to reflect actual increases in expected default rates and credit losses? We find that, controlling for rating, default rates for sponsored issuers and nonsponsored issuers are roughly similar, suggesting that Moody's ratings do appropriately reflect the credit implications inherent in sponsorship. Finally, we assess whether the credit performance of sponsored firms varies in a statistically significant manner with the identity of the sponsor. Credit performance may differ by sponsor to the extent that sponsors differ in terms of expertise, financial strategy, or due to other factors. We examine the default rates of issuers owned by the largest sponsors in our sample, as measured by the number of issuers they own, and find no evidence that credit performance differs across the largest individual sponsors in our sample.

Keywords: private equity, defaults, credit ratings, rating transitions