Commodities Spike, Scarce Credit Hitting LBO Companies Hard

The Financial Times reports on a new, troubling credit crunch phenomenon. Companies carrying a lot of LBO-related borrowings walk a tightrope since the high debt burden gives them little room for error.

But in this downturn features an unanticipated rises in raw materials, plus in some cases, cuts in credit facilities that were important buffers. The combination may lead to an unprecedented level of defaults in LBOs.

In past credit cycles, junk bond default rates peaked at a bit over 15%. But original issue junk bonds were the invention of Michael Milken; prior to him, the only junk bonds were investment grade companies that fell on hard times. The 1990-1991 recession, which followed another corporate buyout binge, was a short, sharp contraction without commodities price pressure. The painful early 1980s slump had both high commodities prices and punitive interest rates, but corporate balance sheets showed much lower gearing than today.

Another departure form the early 1990s: overlevered companies with sound businesses could typically restructure their debt. The FT suggests that companies whacked by input price rises and a funding crisis may wind up being shuttered, which means that aggressive financing won’t hurt only the private equity firms who concocted the deal, but employees and communities as well.

From the Financial Times:

Progressive Moulded Products has become the latest motor parts company to file for Chapter 11 bankruptcy protection,…. Thomas H. Lee is expected to see its $200m investment go to zero while Goldman, which provided a slug of junior, mezzanine debt is also likely to lose everything…

But Progressive’s troubles are not simply those of a private equity-owned firm with too much debt accrued in happier days so that its owners could pay themselves dividends. Instead, Progressive is a victim of the lethal combination of tight credit and rising oil prices. Progressive, which makes plastic injection moulding systems for Detroit’s big three carmakers is one of many parts companies caught in the vice of higher costs and lower sales.

“This is a company that deserved to live,” says one person involved in the restructuring process. “Anyone buying commodities is running out of money and today there is no breathing space for companies if they can’t get credit.”…

The rise in oil prices has struck with increasing severity in the past two quarters. Even two months ago, the industry was forecasting vehicle sales of 15m. Today, that figure has been slashed to 12.5m. The very speed of this change in economic circumstances combined with the contraction in credit means that companies have far less flexibility in avoiding bankruptcy court.

That suggests a new stage in the credit crunch. “Companies are running out of cash because of higher costs and the banks are cancelling revolvers wherever they can,” those close to the restructuring said. Moreover, in the absence of financing, the chances are far greater that a company might be forced to enter into a fire sale of assets.

Progressive had been close to a restructuring out of bankruptcy court…In recent weeks, the banks and bondholders had agreed to recapitalise Progressive and reduce its debt burden. But the agreement fell apart when the carmakers refused to pay in advance for parts because they, too, are in trouble, people familiar with the matter say.

Without support from the carmakers themselves, these other interests were reluctant to make more concessions. A strike at American Axle, another parts maker, slowed production at many plants, putting further pressure on both sides.

The demise of Progressive will come as bad news to lenders who provided junior debt in other deals, expecting to get money back.

“It was fiction to believe that if you provided second lien debt, you were protected,” says the head of restructuring at one investment boutique. “Enterprise values are collapsing.”