Bondholders may suffer if PE-backed cos debts grow-Moody's

NEW YORK Oct 1 (Reuters) - Private-equity firms could add more debt to their target companies' balance sheets in order to reap dividends, which could weaken the position of existing bondholders, a report by Moody's Investors Services said on Thursday.

With credit conditions thawing, private equity firms are likely to refinance or layer on more leverage to companies they have taken public, the report said.

Private equity firms raise funds to buy companies in order to sell them at a later date for profit. They typically exit their investments by initial public offerings or by selling them to a trade buyer. That allows them to make distributions to themselves and the investors in the funds.

While credit protections can restrict those distributions, they often still allow private equity owners and other stakeholders to take cash payouts from a targeted company and reduce its debt servicing ability.

"These credit protections, which are usually less of a concern at issuance, can become critical as economic conditions improve, companies generate more cash flow, and de-leveraging gives way to shareholder distributions as a priority," said Christina Padgett, lead author of the report.

"These covenants may be structured to provide avenues for shareholder-friendly actions that can disadvantage bondholders," said Christina Padgett, lead author of the report.

One way private equity owners can add debt to a company's balance sheet is to side-step a debt incurrence ratio, typically written in bond indentures.

The clause allows an issuer to incur a limited amount of new debt using a ratio based on the company's earnings before interest, taxes depreciation and amortization, or EBITDA.

If the debt incurrence clause is loosely structured, the covenant could allow the shareholder to add presumptive cash-flow to EBITDA, increasing the amount of debt it can incur, even if it has negative free cash flow, Padgett said.

The report highlighted several other indentures that stakeholders may be able to side-step such as restricted payment covenants and change of control put options after a sponsor sells its stake in the company possibly refinancing its balance sheet.

Among deals the report highlights with restrictions are Visant, a 2004 leveraged buyout by Kohlberg Kravis Roberts & Co, which can't distribute more than $200 million in dividends under its debt agreements.

Another is Warner Music Group WMG.N whose owners -- it is part owned by THL Partners and Bain Capital -- have committed to maintaining lower leverage and its debt documents provide "some comfort", the report says. (Reporting by Tom Ryan, additional reporting by Megan Davies; Editing by Diane Craft)