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Private Equity-Owned Companies Show Worrying Signs Of Overleverage

The dangers of private equity firms and their debt-heavy ownership strategies are now more than fodder for a series of anecdotes.

Multiple studies indicate that companies purchased by private equity in leveraged buyouts are at greater risk than ever before of defaulting on their loans, leading to increased fears of an economic downturn, The Wall Street Journal reports.

From the start of 2018 to this September, private equity-owned companies' risk of default has risen from 5.4% to about 6%, according to data from analytics firm Credit Benchmark obtained by WSJ.

By comparison, publicly owned companies' default risk has held relatively steady at around 2.3% over the same period.

When income lags far behind debt obligations, those obligations are less likely to be repaid. When debt is unlikely to be repaid, it drops below "investment grade," making refinancing less likely and liquidation more so.

As the economy has showed signs of wobbling throughout the year, private equity-owned firms are now 250% more likely to default on their loans, Credit Benchmark found. That level of leverage is a warning sign that a recession could be on the horizon, financial services company Morgan Stanley found in a November report reported by WSJ.

About 57% of private equity-owned companies have debt obligations at least six times that of their earnings before interest, taxes, depreciation and amortization, Morgan Stanley found. That percentage is higher than it was in 2007, on the eve of the last financial crisis, when 51% of companies had debt at least six times greater than their EBITDA, WSJ reports. 

Excess debt incurred by a private equity firm's leveraged buyout is what drove Toys R Us into liquidation and has nearly done the same to Sears. That pattern has led to politicians like Sen. Elizabeth Warren (D-Massachusetts) calling for government regulations against such tactics.

S&P Global Ratings expects the proportion of companies forced to default on their debt to grow to 3.9% in September of next year, compared to 2.8% this past September. That percentage is likely to have more impact on the global economy, since the raw number of loans has increased significantly since the Great Recession, WSJ reports.