Turnaround Management poll respondents expect corporate debt default rates to soar past 10% in 2009

By Caroline Salls

Pittsburgh, June 26 - The Turnaround Management Association reported Thursday that turnaround experts predict corporate debt default rates will climb above 10% in 2009 as the credit crunch that bloomed last summer continues to spread havoc among companies that soaked up easy credit.

"The credit crisis prompted and exacerbated by the subprime mortgage crisis will prove a day of reckoning for overleveraged companies, and companies operating on the margin," Arthur Perkins, TMA president and co-head of the West Region Reorganization Services practice for Deloitte Financial Advisory Services LLP in San Francisco, said in the TMA news release.

"The liquidity glut of the past few years allowed many of these companies to borrow at low rates and easy terms, allowing them to defer needed operational fixes. That time has ended."

The association said nearly 70% of turnaround professionals responding to the 2008 TMA Trend Watch credit poll expect a surge of defaults occurring over the next three years.

Half of the poll respondents pinpointed 2009 as the critical year, while 8% thought it might happen sooner and another 8% said they expect it to occur in 2010.

"Default rates on high-yield corporate bonds have spiked in double digits in previous recessions, climbing to 10.3% in 1991 and 12.8% in 2002," James B. Shein, a professor of strategy and management at the Kellogg School of Management who chairs the TMA Trend Watch Committee, said in the release.

"Even though the $1 trillion market is currently defaulting at about a 2% rate, the majority of the respondents believe the defaults will again spike to over 10%, most probably next year."

"As default rates increase, there's no money available for true resuscitation of businesses," Great American Group chief operating officer Tom Pabst said in release.

"I think you're going to see a lot more situations where companies would have been saved in the past but will not be saved in the future because of the lack of available credit."

Borrowing more expensive

According to the release, poll respondents believe that trouble has been building since August 2007 when a well brimming with cheap money abruptly began to run dry.

As a result, 94% of poll participants said credit is tighter, compared to 23% in 2007; 80% noted less activity by traditional lenders; and more than 70% said loans come with more restrictive covenants and greater conditions to be met than last year.

TMA said 53% of respondents said lower EBITDA is prevalent in 2008 when compared to late 2006 when restructuring professionals saw companies being acquired or refinanced at nine to 12 times those earnings.

In addition, this year's respondents said they see constriction across several lending categories, including those considered safer bets for recouping loans to troubled or underperforming companies.

One in four respondents said financing to exit Chapter 11 is tougher to come by, and those who thought debtor-in-possession financing is harder to secure doubled to 21% in 2008 from 10% in 2007, even though that class of financing jumps to the head of the line for repayment in a bankruptcy.

Bankruptcy rules tougher

With less financing available and more constraints embedded in Bankruptcy Code provisions that took effect in 2005, TMA said conventional Chapter 11 filings may become more the exception than the rule, and a trend toward more pre-packaged bankruptcies is already evident.

"We will see some dress-up operational fixes [of debt-laden companies] followed by a quick Section 363 sale or a liquidation," Perkins said in the release.

"This wave is going to bring out the real problems that were created by the new bankruptcy law, which haven't been addressed because too few cases have been filed in the last two-and-a-half years," BDO Seidman LLP partner William K. Lenhart said in the release.

"Now people won't be able to refinance themselves out of their troubles, so the only way they're going to get financing is if they get a DIP."

Hedge funds still a force

TMA said about four of out five 2007 and 2008 respondents said that the influence of hedge funds and other nontraditional capital sources are a fundamental institutional shift affecting the economy.

"The hedge funds continue to be big players," Perkins said in the release.

"They have higher hurdle rates [for yields on investments] so they play in the distressed space.

"I don't think the hedge funds that are in this [distressed lending] space have actually suffered that much compared to the hedge funds that got involved in derivatives, subprime mortgages and other asset classes."

Indeed, TMA reported that respondents said they see tamped-down activity by hedge funds, buyout firms and other entities that are not banks, with 46% of respondents saying those funds remain significant for companies in mid-decline, down from 55% of those surveyed last year; 62% saying those funds are significant for companies acquired by financial buyers, down from 71% of respondents last year; and 32% saying those funds are significant for healthy companies traditionally financed by banks, down from 50% last year.

Also, TMA said asset-based lending represents one class of lender not skittering away from deals, as 51% of those surveyed said they see more ABL activity this year compared to a year ago.

"This is traditional in down cycles where the lenders go back to looking for collateral [tangibles such as equipment and accounts receivable] instead of the so-called air balls based on exuberant cash flow forecasts," Shein said in the release.

M&A funding harder to find

Meanwhile, TMA said the percentage of respondents reporting that financing for mergers and acquisitions is harder to secure doubled to 56% this year from 28% of those polled last year.

It's unlikely, though, that all prospective buyers are scuffling for cash, TMA reported.

"The financial buyers aren't getting the level of financing that they would like for most deals, nor can they get it as cheaply," Perkins said in the release.

"So, they are focused more on companies in which they can make a huge improvement in the operational performance of the company to get their returns.

"We also expect to see more strategic buyers in this space during this downturn, as it is easier for them to reduce cost structure, and many strategic buyers have more cash to invest."

On the other hand, TMA said foreign buyers are enjoying a U.S. spending spree because of the weak U.S. dollar.

"We are feeling a lot of pain, and there's more to come," TeamWork Technologies Inc. CEO William Hass said in the release.

"But internationally we see a lot of foreign private equity coming to the U.S. buying both distressed and healthy assets, and that's going to help some of these companies."

The Turnaround Management Association is based in Chicago.

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