In the paper, Private Equity and the Resolution of Financial Distress, which was recently made publicly available on SSRN, we examine how private equity owners influence the outcome of distressed restructurings and the costs of financial distress. The impact of PE ownership on the likelihood or severity of distress is unclear. There are several reasons to expect a positive role for PE sponsors. The discipline of high leverage could lead to higher operating efficiency and lower the chance of financial distress. Further, if value declines, PE owners have strong incentives to correct this decline to preserve their equity stake, including by committing capital to support the distressed company. PE sponsors also have an incentive to preserve their reputation with lenders and future investors, even when they may lose an insolvent firm during restructuring. On the negative side, actions by aggressive private equity owners to boost their financial return, such as leveraging up a firm to pay large dividends, could drain needed liquidity from PE-owned firms and put these firms at a higher risk of default.
Our analysis of the role of PE sponsors in financially distressed firms proceeds in two steps. First, we examine whether PE-backed firms are more likely to become distressed than other firms with similar operational and financial characteristics. Second, we investigate how PE-backed companies that become distressed manage through the process of resolving distress. To conduct our analysis, we follow a set of 2,156 “leveraged loan” borrowers over the period January 1997 through April 2010, tracking when PE sponsors enter and exit as owners of these firms, and recording when firms default. Borrowers in this market are highly levered, high credit risk firms, and typically pay large spreads on the loans they receive. Virtually all LBO financing occurs through the leveraged market, and most PE-backed firms continue to rely on this market for follow-on debt financings. Non PE-backed firms that borrow in the leveraged loan market have credit profiles that are similar to highly leveraged PE-backed companies, making them ideal candidates for the control sample in our paper. Among the 2,156 firms in our sample, about half (1,062) are PE-backed at some point during the sample period. We find that PE-backed firms have a higher observed default frequency than non PE-backed firms, 5.1% versus 3.4% on average over our sample period. However, once we control for differences in firm characteristics through a default prediction model similar to Shumway (2001), we find that these differences are driven by the higher leverage of the PE-backed firms.
Controlling for the credit rating at the time of the last financing, PE-backing has no impact on the probability of default. Moreover, we find no evidence that recapitalizations used to pay dividends or develop acquisition programs affect default probabilities. Thus, on balance, PE-backed firms are no more (or less) likely to default than other firms with similar financial characteristics. To assess the impact of PE owners on defaulted firms, we focus on four observable measures: the restructuring type (in versus out of court), restructuring outcome (ability to reorganize as an ongoing independent concern), time in restructuring, and recovery rates. Conditional on default, PE-backed firms are more likely to remain independent firms after default, rather than be sold to another company or liquidated piecemeal. Interestingly, this result is driven by PE-backed firms being more likely to survive when they are only financially rather than economically distressed. Moreover, PE-backed reorganizations are resolved more quickly than non PE-backed firms. The differences in time-to-resolution are both statistically and economically significant, with PE-backed firms completing reorganizations four months (27%) earlier than control firms, holding other risk characteristics constant. This result is partially explained by a higher frequency of pre-packaged bankruptcies among PE-backed firms. Within the PE-backed defaults, we also find evidence that firms backed by PE sponsors with more financial and reputational capital are more likely to restructure out of court, resolve their financial distress quicker, and are more likely remain independent after financial distress is resolved. We also find that PE investors play an important role as acquirers of bankrupt assets.
Even though only a small minority of pre-default owners retains control of companies, new PE investors often come in as acquirers of bankrupt firms. In total, about 20% of all bankruptcies end up with a PE fund as the controlling shareholder. The bulk of the results post-default suggest the PE-sponsors help facilitate efficient restructurings and thus lower the cost of financial distress. Recovery rates provide a measure of the success of a distress-related restructuring by estimating how much value creditors recover from the restructuring relative to the promised value of their claims. We find that recovery rates to creditors are in fact lower when the company is PE-backed. This is primarily driven by a lower recovery to bonds for the PE-backed defaults, while bank loan recovery rates are more similar across the PE- and non-PE-backed groups. These results mirror those of Kaplan and Stein (1993) who show that junk bond investors bear the majority of the credit losses after the late 1980’s buyout boom. In the light of the positive efficiency results on restructuring outcomes and time in default, we believe that there are two likely explanations for these lower recoveries. First, PE-backed firms enter default with higher debt levels (consistent with their lower asset to debt ratios in bankruptcy). Second, PE-backed firms could be more successful in restructuring their debt in default via concessions from bondholders.
The full paper is available for download here.