It's Risky to Be a Creditor in This Private Equity World

(Bloomberg) -- Credit investors who’ve plowed billions of dollars into private equity-sponsored LBO debt will be hit hard when the credit cycle turns and defaults rise, Moody’s Investors Service warns in a new report.

The giants of the PE world have used their imposing status to loosen terms on the bonds and loans they sell to yield-hungry investors, says Neal Epstein, a senior credit officer at Moody’s. That gives them more room to preserve their investments in a downturn -- even if it means losses for creditors.

“The investor demand for this debt is so strong that if the private equity sponsors want to borrow more money for their companies and do it with weaker terms, they can,” said Epstein. His report, published on May 7, named KKR & Co., Apollo Global Management, and Blackstone Group as firms that helped write this playbook.

When it comes time for these firms to negotiate with creditors in situations of corporate distress, they’ll be able to call more shots, because they’ve sold the debt under terms that allow them more flexibility than the typical issuer. Plus, the specialized nature of some of these instruments gives them extra advantages.

Debt issued by large private equity firms features few of the lender protections once typical of junk-rated debt, Moody’s said, such as the right to limit cash distributions or additional debt incurrence. That means when these companies default, debtholders have little recourse to protect their investments.

The largest PE firms have enough influence over lenders to maintain control of their assets while in default, Epstein wrote, and -- perhaps most significantly -- to engineer distressed debt exchanges, which can preserve their own equity positions while saddling creditors with losses.

Moody’s data from 1987 to 2018 showed that companies owned by large private equity firms avoided bankruptcy in favor of distressed debt exchanges in 35% of default scenarios, while companies with no private equity ownership did so just 15% of the time.

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