New Study Examines Bankruptcy and Recovery Among Private Equity-Backed Firms

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Private equity firms—firms that finance acquisitions of other companies using substantial amounts of debt—are frequently characterized as the vultures of the finance world, swooping in to strip what value they can out of the newly debt-laden companies, then abandoning them to bankruptcy and liquidation.
But is such a characterization warranted? According to “Private Equity and the Resolution of Financial Distress,” a study presented at the January 2012 American Finance Association Meeting, the answer is a clear “no.”

The study, co-authored by Edith Hotchkiss of the Carroll School of Management at Boston College, David C. Smith of the McIntire School of Commerce at the University of Virginia, and Per Stromberg of the Institute of Financial Research at the Stockholm School of Economics, sought insight into two primary private equity-related questions. First, are private equity-backed firms more likely to declare bankruptcy than other debt-laden firms? Secondly, if bankruptcy is declared, how does the restructuring and recovery process of private-equity backed firms compare with that of non-private equity-backed firms?

“There’s a significant body of research, going back to the 1980s, on the various benefits of private equity ownership,” says Smith. “We wanted to see if there was a downside to having so much debt; we were curious to know what happens to private equity-backed companies when they hit a bump in the road—when they become unable to meet their financial obligations.”

To this end, Hotchkiss, Smith, and Stromberg compiled a pool of 2,156 “leveraged loan,” or high-credit-risk, corporate borrowers, 991 of which were backed by private equity firms—that is, acquired via a leveraged buyout by a private equity fund such as Bain Capital, The Carlyle Group, or Goldman Sachs Capital Partners. The period of analysis spanned some 13 years, from 1997 to 2010.

Their findings? Private equity-backed firms were indeed more likely to default than their non-private equity-backed peers; overall default rates for the two groups were 5 percent, versus 3.5 percent, respectively, on an annual basis. Critically, however, Smith points out, this difference in default rates was driven by the fact that private equity-backed firms, as a group, tended to have more debt and lower credit ratings at the time of buyout financing. Controlling for differences in credit ratings at the time of the granting of the loan, there was no difference in default probability for private equity-backed firms compared with other firms.

Moreover, Smith says, “we also have to recognize that when a company goes into default, it’s not the end of its life—it’s more like a bump in the road.” Indeed, he says, it’s how the company moves forward that really matters. “Oftentimes a firm comes out significantly stronger after a default and restructuring,” he points out.

In this regard, the study found that private equity-backed firms fared better than their debt-laden brethren. Upon entering bankruptcy, private equity-backed firms moved through the bankruptcy process about 30 percent faster than those in their peer group; were more likely to enjoy smooth, “out-of-court” or so-called “pre-packaged” agreements, and, critically, were far more likely to exit the bankruptcy process as intact, independent firms. Smith and his colleagues attribute these differences to private equity investors’ professionalism and reputational stake in the industry.

“There are plenty of things not to like about private equity investors,” Smith says. “They’re known for having big egos, for hosting obnoxious parties. But—when we look at the data—we can’t accuse them of turning their backs on the distressed companies.”