LBO companies' health could be worse than it looks

NEW YORK (Reuters) - The health of a stack of companies taken private during the go-go years of private equity may be obscured in 2008.

Defaults for leveraged loans -- the debt behind much of the buyout wave that peaked last year -- have been at the lowest rate in years. The default rate is an indicator often used to measure the well-being of leveraged buyouts.

The U.S. leveraged loan default rate ended 2007 at a 10-year low of 0.1 percent for Moody's-rated issuers, down from 0.6 percent in 2006. But that seemingly sunny development may mask a gloomier picture going forward.

The problem is that the most recent round of dealmaking partly removed a canary in the coal mine traditionally used by lenders to signal when a deal was in trouble.

"The default rate is historically low because there are less defaults in the deals to trigger," said Brian Trust, a partner at law firm Mayer Brown LLP who works on bankruptcies and restructurings. "Transactions that were consummated over the past few years typically had very light or no covenant packages."

Lending agreements from the buyout boom had such loose conditions that some were dubbed "covenant lite" because they lacked traditional default triggers called maintenance covenants. Those covenants track a borrower's ability to meet financial obligations.

Historically, a company that issued leveraged loans would break a maintenance covenant if it ran into liquidity trouble, said Kenneth Emery, who directs Moody's corporate default research. Lenders would then be alerted to the situation early and could take corrective action, like selling assets, changing management or pushing the company into bankruptcy, according to Emery.

But without such strict covenants, the default rate could react less to liquidity issues at newly private companies -- which may be at higher risk in a recession due to the debt load that often accompanies a buyout.

"We may not see as many defaulters, other things being equal, as we would have historically because of the lack of covenants," said Moody's Emery. "The option to push the issuer into bankruptcy or default isn't there for the creditors."

Covenant lite deals accounted for 10 percent of the nearly $690 billion in leveraged loans issued last year, according to Reuters Loan Pricing Corp. That's up from just 4 percent in 2006.

The Reuters Group Plc RTR.L unit defines covenant lite as a leveraged deal that has one maintenance covenant, such as a measure of debt to cash flow, or none at all. A loan is technically in default once a covenant is blown.

DELAYING DEFAULTS

It's unclear to analysts just how much the lack of covenants may suppress the leveraged loan default rate in the coming year.

"<The default rate> will certainly rise less because of covenant lite deals than otherwise; but I don't know how much that will really move the needle." said Chris Taggert, a senior loan strategist at research firm CreditSights. "That's because we have to assume how many covenant lite deals would have actually been pushed into default had there been covenants."

But with Moody's Emery already forecasting that the U.S. leveraged loan default rate will jump to around 3 percent this year, any muting of solvency issues for borrowers may be significant.

Moody's expects the highest rate of U.S. defaults in 2008 to be in the construction and building industry, where $14.2 billion in U.S. buyouts were announced last year, according to data provider Dealogic. That was up from $6.3 billion in the prior year.

Ultimately with covenant lite loans, there may not be much value left for lenders to recover by the time a borrower goes into default.

"Covenant lite loans could delay the increase in defaulting issuers," said Moody's Emery. "This could mean the recovery rates could be also lower than they have been historically. That's because the value of the company may have diminished much more than it would have if the creditors could have pushed it into bankruptcy earlier."

(Editing by Gerald E. McCormick)