LBO companies' health could be worse than it looks

By Jonathan Keehner and Megan Davies

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.