Private Equity is sliding into a debt crisis, as indicated by data from the credit rating agencies Standard & Poor's and Moody's. Heavily indebted companies owned by private equity firms are increasingly struggling to meet the rising interest payments, especially considering that they often have poor credit ratings. "Of the companies with a rating of B1 and below, around 70% are owned by private equity firms in the United States, and approximately 60% in Europe," says Jeanine Arnold, Associate Managing Director at Moody's in Paris, to Börsen-Zeitung. Adding to the challenge for many companies is that investment firms often generate their returns through substantial dividend withdrawals from their portfolio companies, which increases their debt levels.

In recent months in Germany, due to overindebtedness and the failure to make interest payments, several companies, including the printing supplies provider Flint Group, the nursing home operator Emvia Living, the elevator parts manufacturer Wittur, and the fashion discounter Takko Fashion, shifted ownership from entities such as Goldman Sachs, Bain Capital, and Apax to private credit creditors, including Ardian, KKR, and Silver Point Capital.

After a long period of low interest rates, that boosted demand for leveraged buyouts (LBOs), many companies in Europe find themselves confronted now with high financial indebtedness under challenging market and economic conditions. "About 70% of the companies in Europe are rated B2 and below, which is the highest level in more than ten years," summarizes Moody's analyst Arnold.

"About two-thirds of these companies are LBOs, which typically have a high debt-to-equity ratio, weak interest coverage, and low or negative free cash flow." Rising interest rates, coupled with weaker earnings, market volatility, and reduced market liquidity, have already affected the credit quality of some of these companies.

In Europe, the percentage of companies rated B3 negative and lower reached 15% in March 2023, exceeding the long-term average. "At the same time, about 20% of rated companies in Europe owned by financial investors will have most of their debt maturing between 2023 and 2025," explains Arnold. "Approximately 80% of these companies have a rating of B3 or lower." Consequently, a wave of credit defaults is expected in 2024.

S&P credit analysts are also increasingly observing defaults among companies owned by private equity firms. "Debt-to-equity swaps turn creditors reluctantly into owners," notes Patrick Janssen, Director Leveraged Finance at S&P in Frankfurt, to Börsen-Zeitung. "We classify that as a credit default." This is because the return and value of equity become uncertain and cannot be compared to the predictable interest payments on bonds.

Debt levels usually decrease when creditors involuntarily become owners, and maturity dates are often renegotiated. "In most cases, the rating is higher after a debt-to-equity swap than before," says Janssen. "In some cases, creditors also provide new loans, usually with higher interest rates, as liquidity support." The new owners may contribute to restoring confidence in the debtor company within the capital market.

For more than a third of companies experiencing defaults in 2022, the reasons were self-inflicted and not due to sectoral or economic developments. "We expect an increasing trend in debt-to-equity swaps," believes Janssen. "It has already happened this year with Takko Fashion, Wittur, and Flint Group." Meanwhile, the economic situation is becoming more challenging.

In the speculative grade category below "BBB-", 9% of the companies are rated CCC or lower, indicating an "unsustainable capital structure." "Before the pandemic, this figure was only 6%," analyzes Janssen. "Therefore, we anticipate the default rate in the speculative grade category to rise over a twelve-month period from 3.05% in mid-2023 to 3.75% in mid-2024." This is more than before, but still significantly lower than in 2020 at the start of the pandemic or in 2009 during the financial crisis.

In Europe, it would mean that 28 companies are going to default. In Germany, out of ten companies with a "CCC" rating, only three have an elevated risk of default within the next twelve months: Wittur, Arvoz, and Tele Columbus. The companies with the highest debt burdens in the lower-rated "B-" category and below include Adler Group (€3.8 billion), the perfume chain Douglas from the portfolio of financial investor CVC (€2.7 billion), and Klöckner Pentaplast owned by Strategic Value Partners (€2 billion).