Zombies Stalk Private Equity

Well. at least we have a new addition to the finance scene that isn’t an acronym. A zombie deal is what happens when a LBO transaction with a cov-lite loan goes bad. Recall that “cov-lite” was a sign of how frothy lending conditions had gotten. Just think, a mere year ago, a private equity firm could borrow gobs of money and lenders would willingly abandon their traditional protection (covenants) that among other things, allowed them to declare an event of default and accelerate the principal (which in practice usually leads to penalties and/or a renegotiation of terms.

But now, these dodgy deals can’t be forced into a restructuring or a bankruptcy (at least not by the bondholders).

Note that what appears to be a minority of private equity firms is trying to do right by the lenders, The Financial Times explains:

What do a Spanish clothing retailer, an Irish telecommunications group, a German maker of plastic packaging film and a French house-builder have in common?

They are all so-called “zombie” companies, bought by private equity in heavily leveraged deals shortly before the debt bubble burst last summer and now judged by investors to be worth less than they owe to creditors.

“These are zombies, companies with unsustainable financial structures but no triggers for the banks to force them to renegotiate,” says Edward Eyerman, head of European leveraged finance at Fitch.

They include: Cortefiel, the Spanish clothing vendor acquired by PAI, Permira and CVC in 2005; Eircom, the Irish telecoms group bought by Babcock & Brown in 2006; and Klöckner Pentaplast, the German plastic film maker sold to Blackstone last year.

Cortefiel’s senior bank debt was recently quoted at 67 per cent of its par value, suggesting that the equity owned by the private equity firms is worthless.

Klöckner and Eircom also have debt trading at discounts of 15-30 per cent to par.

Kaufman & Broad, the French house-builder in which PAI bought a majority stake in July 2007, is another case of a company bought at the peak of the market.

Shares in Kaufman & Broad have lost half their value since the deal amid a trading slump, while Calyon and Merrill Lynch have been unable to syndicate the €1.4bn ($2.1bn) of debt they issued to finance the bid, raising doubts about what value is left for PAI.

The list of companies in similar situations is long.

But their private equity owners mostly shrug off the problem, pointing out that often covenants on the debt are either very loose or non-existent, so they have time to wait for conditions to improve.

Paul Drake, Standard & Poor’s head of leverage finance and recovery in Europe, says: “Most private equity firms’ reaction when the market tanked last year was that it was not their problem.”

Mr Drake adds that banks’ loan recovery rates could fall if they are without the tools to rein in problem companies.

“There is no trigger to bring private equity to the table, so you have to ask if loss rates will be higher. That is a real risk,” he says.

Private equity firms may suffer if they end up owning “zombie” companies for longer, reducing their returns.

In a survey of 100 private equity executives, to be published Tuesday by Grant Thornton, more than half said they expected hold periods to lengthen.

Banks are looking for any opportunity to force “zombies” to renegotiate.

Some already have and in most cases private equity owners seem willing to inject more equity, such as Candover in Ontex, the Belgian nappy-maker, or Kohlberg Kravis Roberts in ATU, the German auto-repair company.

Most buy-out bosses say they would fight before letting a company default.

“We have 20 to 25 deals in our portfolio and really can’t afford to lose any of them,” says Martin Halusa, head of Apax Partners, at this month’s EVCA conference in Geneva.

Kurt Bjorklund, co-head of Permira, says he would “consider on a case-by-case basis whether it is a good incremental investment” before injecting more equity.

In the end, a private equity firm’s decision is likely to depend on many factors, such as how much equity they have taken out by refinancing, how much reputational damage it would suffer in case of default and whether it thinks the company can recover.

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