Credit rating agencies are forecasting rising levels of bond defaults due to Covid-19 – but these gloomy predictions may underestimate the readiness of private equity backers to recapitalise struggling companies or overstate the need that such cash injections may be needed.
That is the calculation that some fixed income-focused investment heads are making at regional institutional investors.
“Everyone is assuming all these companies will default, but a lot of their debt could be reduced by general partner owners drawing down equity to pay back debt and reduce leverage,” said a Hong Kong-based chief investment officer of a life insurer, who asked not to be named.
“[Private equity firms] have raised so much money [that] if they think there is a temporary cashflow problem [in the businesses they own] due to Covid-19, they can address it. People are underestimating the readiness and capacity to do this,” he said.
Globally, private equity firms back two-thirds of the 412 companies that are rated Caa1 or below (or are rated B3 but at risk of downgrade to Caa1) by Moody’s – or a total of 273 firms.
The entire group today is 40% larger than it stood at during the height of the global financial crisis of 2008. In April, six out of at total of 23 defaults by corporate bond issuers globally were in Asia, according to Moody’s.
Chris Padgett, head of leveraged finance at Moody’s, has predicted that bond default levels could rival those seen during that crisis.
Similarly, rival agency S&P Global Ratings predicted in March that default rates among high-yield bonds would rise to 10% over the next 12 months, more than triple the 3.1% recorded at the end of 2019.
However, Asia may prove an exception to these dour forecasts because of the high level of private equity investment in the region. GPs would be more likely to prevent defaults, argued Sweta Chattopadhyay, London-based head of private equity at investment consultancy bfinance.
“From an equity owner perspective, you want to protect your equity position. It will take a lot for private equity owners to walk away,” she said, adding that the reputational damage could also be severe.
GREATER FREEDOMS SOUGHT
Chattopadhyay said conversations in Asia and beyond are taking place between limited partners (investors) and GPs to change constraints surrounding investment funds and allow greater freedoms. These could include the ability of the fund to invest in debt or additional equity or to breach existing limits, in order to pursue opportunities.
“The big thing will be about liquidity; a lot of these companies face a liquidity crunch in the short term that will become a solvency issue in the mid-term,” she added.
Not everybody believes GPs will face a major need to inject further capital to companies to avoid defaults. Kent Chen, Asia Pacific head of private equity at US fund house Neuberger Berman, which invests in PE funds and co-investments, said such moves are not likely to be common.
“Such action is less likely for Asian companies owned by PE funds,” he told AsianInvestor, noting that leverage for these funds’ equity stakes in such companies was typically lower than in Europe or the US.
While he does not anticipate many GPs having to step in, he added that he would not mind seeing companies recapitalised by GPs if they felt it were required to survive the current challenges.
The exact number of companies that will require help with debt coverage or extra cash injections is difficult to predict.
Chattopadhyay said it was hard for rating agencies to form a clear picture of the financial health of these companies when their GP owners are unsure themselves.
“Private equity funds are still calculating the impact on income, revenues, profit-and-loss accounts, and so forth. If the owner is still figuring it out and the valuations aren’t updated yet, how can the rating agencies have a view on this?” she said.
The high level of private debt among private equity-owned companies judged to be at risk of default by rating agencies makes them hard to accurately evaluate, with agencies likely to be too cautious, Chattopadhyay added. “Generally speaking, I would view [agencies’ default predictions] with a little bit of scepticism.”
Moreover, the criticism faced by rating agencies following the global financial crisis that for being lenient in their ratings will probably make them over-correct and be too pessimistic about default rates this time around, Chattopadhyay added.
The Hong Kong based insurer CIO took a similar view. “The rating agencies have changed their behaviour; they are almost too quick to downgrade now, the opposite of having been too slow to downgrade during the global financial crisis. But this is quite a different environment.”