The ratings agencies are newly emboldened, or perhaps feel the need to look tough where they can to make up for their tattered reputations elsewhere.
The latest salvo: Moody’s has announced that it will take a haircut to the debt ratings of companies owned by buyout firms that engage in “aggressive” financial strategies. The more accurate terminology might be, “We take all the cash and leave you saps with the husk of a company.” Moody’s has decided it doesn’t like that sort of thing since it is mean to bondholders.
Now, of course, the question is where Moody’s et alia were all these years when the companies they complain of engaging in these so-called dividend recaps on a serial basis were executing these transactions? This was going on in broad daylight; indeed one of the perps who didn’t do it often enough to make the list of regular suspects, Clayton, Dubliler & Rice, was roundly pilloried in the press when it sucked a lot of money out of acquired company Hertz a mere six months after closing. It’s hard to claim that the funds you are extracting at that juncture are the result of operational improvements. Since CDR likes to maintain its image of being a clean, upstanding acquirer of unwanted corporate divisions, the press may have had a deterrent effect on them. But clearly not on others.
Of course, there are defenders of dividend recaps. Bank of America cites Standard & Poor’s research that found that companies that underwent dividend recaps had lower default rates than most LBOs (reason: only the fittest are targets for this strategy). But if you read the underlying S&P report, it is negative about the development, anticipating intermediate-term problems even if the near-term results have looked fine.
My beef with the Moody’s approach is that it is a ham-handed solution. It punishes recividists across all deals, and leaves the firms who have not done these sort of financial stripping operations (or at least not done them often) freer to do so.
Why the hesitation to downgrade the debt more severely when the recaps take place? That ought to make lenders impose tougher terms on borrowers, perhaps even covenants that make dividend recaps tough to execute. While I am no fan of this strategy (see here), it would seem to make sense to have a remedy better targeted to the problem.
From the Financial Times:
Moody’s Investors Service will on Tuesday warn that it will adopt a tougher stance when rating companies owned by private equity groups that were more “aggressive” in the most recent deal making cycle.
This could put companies owned by more aggressive buy-out firms at a relative disadvantage amid the economic downturn as they seek to strike new deals once the credit markets improve.
In a report, Moody’s corporate finance group ranked buy-out groups by their propensity to take out cash dividends from their US investments since 2002. Welsh Carson, Cerberus, Providence Equity Partners, Carlyle, Madison Dearborn and THL topped the list. KKR, Blackstone and Bain Capital were less frequent users of such “dividend recapitalisations”, Moody’s said.
Dividend “recaps” are controversial because they allow private equity owners to extract profits quickly and eliminate risk from a deal, while often leaving portfolio companies in a more precarious financial position.
“The interesting aspect is finding out which firms support their companies and which firms don’t,” said John Rogers, senior vice-president at Moody’s corporate finance. “At the start of the next up cycle, we will be much more cautious in how we rate these firms.”
Moody’s says the purpose of the study – which examined buy-out deals rated for over a year – aims to highlight how “insights into how top sponsors carry out their financial strategies can help shape initial rating decisions”. It also offers investors a chance to be in a “better position to gauge potential for ratings changes”.
Welsh Carson, Providence, THL, Madison Dearborn and Cerberus declined to comment. Carlyle said: “Prudence and a company’s ability to safely service debt dictate the capital structure of our portfolio companies. That’s been our benchmark for recapping in the past and how it will be done in the future.”