The dark side of the buyout boom

NEW YORK (CNNMoney.com) -- For as long as private equity has dominated the business pages, a question has hung over the industry: When will the flow of cheap money fueling the buyout boom run dry?

A new study from Moody's Investor Service predicts that defaults by the riskiest corporate issuers will jump by the end of the year, suggesting the tide is starting to shift in the credit markets.

Historically low default rates have been one of the reasons lenders and investors have been eager to finance buyout deals, which often involve the issuance of high-risk, high-yield bonds or loans.

The default rate among the riskiest corporate bond and loan issuers fell to 1.57 percent last year, the lowest level since 1981, according a study issued by Moody's on Thursday. But the rating agency expects the default rate to nearly double to 3.07 percent by the end of the year.

Cheap debt has driven the dizzying pace of leveraged buyouts, and the supply of money has seemed limitless even as buyout firms have set their sights on ever bigger deals.

Nine of the 10 biggest buyouts have occurred in the last three years, and the targets keep getting bigger. Blackstone Group's $39 billion takeover of Equity Office earlier this month takes the cake when it comes to the largest buyout ever. The value of the deal includes debt. (Top 10 deals)

Market watchers have been anticipating defaults to rise from historically low levels for the past few years, but so far that's failed to materialize.

"A lot of the time people are financing their way out of problems," Justin Hillenbrand, partner at Monomoy Capital Partners, a buyout firm that focuses on turning around companies, said about the relative lack of defaults.

Instead of fixing operational problems at a company, they're just borrowing more money to stay afloat, he noted.

Hedge funds and other big investors around the world looking to put their money to work have been eager to come to their aid, especially when it comes to purchasing so-called leveraged loans.

Leveraged loans - which are issued by highly indebted companies and are below investment grade - skyrocketed to a record $480 billion last year, up 60 percent from 2005, according to Standard & Poor's.

But credit fundamentals are deteriorating and defaults are set to rise, said David Hamilton, director of corporate default research at Moody's. "There have been a lot of temporary conditions keeping the default rate low, but ultimately there are going to be defaults," he said.

The risk of default tends to rise in the third and fourth years after debt is issued, what Hamilton refers to as the "aging effect." Given the low average initial credit quality of the debt issued in 2003 and 2004, defaults are likely to ramp up this year and next, he said.

But even though defaults may rise, that may not be enough to slow down the private equity machine. Moody's projected default rate of 3.07 percent by year-end is still below the average 4.9 percent default rate since 1983, according to the rating agency.

John O'Neill, Americas director of Ernst and Young's private equity practice, said it would take a significant jump in defaults to really jolt the buyers of these risky loans and bonds.

Rather than curtail activity in the private equity sector, a slight rise in defaults could spur even more transactions in another part of the market - the distressed debt market.

"There's $30 billion in funds that private equity firms have set aside for the distressed market that's still sitting on the sidelines because there's not a lot of distressed debt to buy," he said.

So-called distressed debt - bonds and loans of companies that have entered into default or are likely to do so - can be attractive because of their high yield, meant to compensate investors for the increased risk.

Default rates are already so low, they have nowhere to go but up, said Steven Miller, who tracks the leveraged loan market for Standard & Poor's.

Instead, it'll take a real spike in defaults for suppliers of cheap money to reassess their perception and tolerance of risk, he said.

That could occur if there's an overall downturn in the economy or if an external event - like a hurricane or a major geopolitical incident - jolts financial markets.

"At some point an economic slowdown will put pressure on earnings and drive default rates higher, but no one has a crystal ball for knowing when that will come about," Miller said.

Private equity insiders are bracing for a fair amount of pain what that happens. "It only takes a few large defaults for the lending community to snap back and it'll snap back pretty hard when it does," said Monomoy Capital's Hillenbrand.

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