By Lisa Allen

When TowerBrook Capital Partners LP acquired denim designer True Religion Apparel Inc.in July 2013 for $824 million, the New York private equity firm was able to get what many private equity firms got after one of the worst financial crises in U.S. history: covenant-lite financing.

TowerBrook, which specializes in retail buyouts, bought True Religion even though it had suffered a profit decline and faced intense competition in the denim space. Intent on “brand building and international opportunities,” as it called it, TowerBrook brought in David Conn, former president of licensed brands at VF Corp., as True Religion’s new CEO soon after the buyout.

But True Religion’s high price point and fickle customer base-celebrities such as Britney Spears and Jennifer Lopez have been photographed in its jeans-undermined TowerBrook’s plan and only continued the earnings slide, weakening the jeans maker’s balance sheet.

Conn was replaced in June by John Ermatinger, an expert in managing U.S. manufacturers’ Asian operations, and on Dec. 18, Standard & Poor’s warned in a report that True Religion has “significantly declining customer traffic” and “sharply declining earnings,” factors that are eroding liquidity. While True Religion has no financial maintenance covenants or near-term debt maturities, S&P’s report said its capital structure that could be unsustainable without a “meaningful performance improvement.”

According to a March 17 report by Moody’s Investors Service Inc., True Religion has a high debt-to-Ebitda ratio of around 7.5.

True Religion’s situation isn’t unique. Companies that were bought out by private equity firms around 2011 through 2014 are especially vulnerable to overleverage because they “tend to have fairly aggressive capital structures put on them,” said Charles Boguslaski, a partner at turnaround firm Carl Marks Advisory Group LLC.

Telling, too, is that much of the distress striking PE-backed firms of that vintage is rooted in stagnant top lines. Companies in commodities-related industries are being crushed by such things as low oil prices, but there are retail and manufacturing businesses, like True Religion, that have little or no sales momentum.

“One of the buried stories in the bull market of the last four to five is years is a lack of revenue growth,” Boguslaski asserted.

Poor sales performance only exacerbates the leverage issue. But it’s been hard to get a read on many of these PE portfolio companies. Financial debt covenant compliance provides some benchmarks. But with many PE-backed companies from that period, the debt either carries few covenants or none at all. Typically, covenant-lite financing lacks certain traditional financial performance requirements that allow lenders to intervene if a borrower’s results decline.

“The problem is, a lot of [companies] don’t have covenants,” one restructuring adviser groused. “The only covenant is the fact that they’re going to run out of cash.”

It seems strange, only three years after the entire banking system nearly collapsed, that there were lenders again providing loans with such little accountability. But with the FederalReserve keeping interest rates low to encourage economic growth, big investors found themselves with few places to put their money. Yield again became more important than credit quality.

“It was easier to get more highly levered deals done [around 2011 to 2014] because institutional investors were chasing yield,” according to James Gellert, chairman and CEO of Rapid Ratings International Inc., a firm that provides quantitative analysis of companies’ financial health.

The tenor of the market has changed now, he said. Amid the current bond market volatility sparked by a brutal commodities downturn, Gellert believes institutional investors will stop chasing yield quite as aggressively.

The timing couldn’t be worse, since total outstanding fixed income is double its 2007 level, he noted.

“Now we’ve got a much larger mountain to refinance,” Gellert added.

The refinancing pipeline is full, but clogged. Fitch Ratings Inc. said in a March 22 report that “a slew of debt deals have been delayed given challenging market conditions. The weakness in both institutional loan and high-yield issuance so far this year, as well as the low amount of loan maturities in 2016, would suggest that 2016 issuance should be down slightly from 2015.”

According to Fitch’s data, high-yield bond issuance was down to $21 billion during January and February, with leveraged loan issuance at $23 billion. Compare that to $86.6 billion in HY bond issuance and $44.4 billion in leveraged loans issuance in the first quarter of 2015.

“You’re starting to see early warning signs of credit tightening,” Carl Marks‘ Boguslaski said. “Dividend recaps are down, second-lien and covenant-lite issuance are down.”

Meanwhile, consider the possible overhang of bonds that need refinancing. It’s like a storm cloud over a pond. Leveraged loan issuance rose each year from $185 billion in 2010 to $625 billion in 2013, and then eased down to $451 billion in 2014, according to Fitch. HY bond issuances trace the same trajectory on a smaller scale, increasing from $185 billion in 2010 to $307 billion in 2012 and finishing 2015 at $251 billion. But anyway you slice it, a lot of rain could possibly fall.

PE-backed companies with covenant-lite loans that don’t trigger any penalties when a debt-to-Ebitda ratio skyrockets have yet to face their reckoning. Witness 32-times-levered Britax Group Ltd., according to an Aug. 19 report from S&P. The children’s car seat and stroller maker, a portfolio company of private equity firm Nordic Capital since 2011, didn’t reply to queries about whether the ratio has improved. And besides its heavily leveraged balance sheet, Britax Group has had to run multiple safety recalls for its products in recent years.

Nor is True Religion the only PE-backed denim maker with challenges ahead. NYDJ Apparel LLC is a denim designer with a very different customer base, but it, too, had a balance sheet issue to contend with. The maker of Not Your Daughter’s Jeans has had to tweak its capital structure as it works on a turnaround. Its financial sponsor, New York-based Crestview Partners LP, forgave a portion of debt owed to it in August in order to ensure its covenant compliance following a January 2014 buyout.

NYDJ has lower prices than brands such as True Religion, and its price point and style-classic slimming jeans rather than risky bets on new trends-have helped it weather a difficult time for denim sales better than some of its competitors. But Moody’s, in an Aug. 25 report, noted that NYDJ’s debt is nearly six times its Ebitda and that future convenant tightening will create pressure going forward.

Irvine, Calif.-based dental office operator Smile Brands Group Inc. received a waiver of a covenant breach alongside a $30 million equity infusion from its PE backer, New York-basedWelsh, Carson, Anderson & Stowe, on Oct. 9. But Standard & Poor’s warned that those fixes won’t be enough given the portfolio company’s negative cash flows and the fact that adjusted debt is over 10 times Ebitda.

When Welsh Carson bought a majority stake in Smile Brands from fellow PE firm Freeman Spogli & Co. for $600 million in November 2010, it larded $340 million in debt on the company. On Feb. 29, S&P said in a report that Smile Brands’ CCC+ rating with a negative outlook reflects intense competition, a tough environment for reimbursements, and the company’s “need to reverse operating trends in order to avoid a liquidity event in 2017.”

What may be softening the blow so far is the relationship financial sponsors have with lenders. Not surprising, said Rapid Ratings’ Gellert, since banks have an interest in maintaining longstanding relationships with firms that bring them deal flow.

“I imagine you’re seeing banks being more accommodating to private equity-backed companies than to someone coming in off the street,” he asserted.

State College, Pa., oil and gas E&P Eclipse Resources Corp., formed by Houston buyout firmEnCap Investments LP and Eclipse’s management in 2011 with a $150 million equity commitment, has thus far barely avoided a covenant breach. Moody’s cautioned in a Jan. 9 report that Eclipse was likely to breach its interest coverage ratio during the fourth quarter of 2016, but the company announced March 2 that its revolving credit facility has been amended to ease that covenant in 2016 and early 2017.

In the oil patch, Eclipse may end up being one of the lucky ones.

“Covenant concerns are most acute in the commodities-based industries,” said Michael Paladino, head of leveraged finance at Fitch Ratings, noting that companies involved with oil and gas exploration and production and coal have been hit the hardest. “I don’t think anybody was expecting the declines in energy prices that we’ve seen.”

Issuance figures for high yield bonds and leveraged loans in the energy industry chart a balloon in new debt that didn’t deflated until the second half of 2015. According to data compiled by Fitch, energy companies issued $36.8 billion in high yield bonds and $7.3 billion in leveraged loans in 2010, a figure that crept up in 2011 and jumped to $57.4 billion in HY bonds and $20.3 billion in leveraged loans in 2012. Issuance remained in that ballpark through 2014.

Commodities companies that took advantage of post-crisis optimism to lever up are in an especially precarious position.

Slower-than-expected economic growth, particularly in China and India, has failed to stoke the commodities demand investors were betting on, and supply has generally remained plentiful.

Among PE-backed energy companies acquired between 2011 and 2014, those struggling with their capital structures include Templar Energy LLC, Fieldwood Energy LLC, and Nesco LLC.

Templar Energy, formed by energy-focused financial sponsor First Reserve Corp. in December 2012, managed to amend its financial covenants last year down to a single requirement-a minimum interest coverage ratio of 1.3 times through the quarter ending June 30, 2017, which will increase to at least three times after that date, according to a March 15 report from Moody’s

Even so, the ratings agency said the Oklahoma City-based oil and gas explorer and producer has an over-leveraged balance sheet with $1.95 billion in debt outstanding on it that is “likely to require restructuring,” especially since Templar has hired advisors to explore strategic alternatives. Moody’s didn’t name the advisers, and Templar didn’t respond to requests for comment.

Fieldwood Energy, which New York buyout firm Riverstone Holdings LLC in 2012 invested $600 million in, faces “high covenant violation and borrowing base reduction risks” this year, among other problems, Moody’s said in a Feb. 16 report. Unless oil prices improve dramatically, the Houston oil and gas E&P isn’t likely to generate enough Ebitdax-a measure that adds exploration expenses to the factors excluded in Ebitda calculations-this year to satisfy the covenants on its credit facility, the ratings agency said. Currently, Fieldwood has $3.3 billion in debt.

“Without a significant debt reduction or some form of debt restructuring, the company will not survive a prolonged downturn,” Moody’s warned.

Then there’s Nesco, which rents equipment to the electrical transmission and distribution market. Energy Capital Partners LLC acquired the Fort Wayne, Ind., company from fellow buyout firm Platinum Equity LLC for an undisclosed price in February 2014. Nesco, which issued $525 million in second-lien notes and has a $250 million first-lien revolving credit facility, is at risk of breaching a covenant or missing a debt payment absent a performance improvement or capital expenditure cutback, S&P said in a Feb. 5 report.

What dims hope that there’s a refinancing panacea around the corner is something that exists now that didn’t in 2011. Banks and other regulated lenders have increasingly limited flexibility to help debt-laden borrowers because of federal leveraged lending guidelines released in 2013. Under those rules, a debt-to-Ebitda ratio above six times will attract regulatory attention. That makes many of the 2011 to 2014 buyouts toxic as refinancing candidates, as some of the aforementioned examples can attest.

Non-regulated lenders such as Jefferies Group LLC see an opportunity. But there’s still a hitch, even for the willing.

“The only way you can earn returns buying into companies with those multiples is if they have revenue growth,” Boguslaski explained. “As you start to see companies come up for maturities again, they haven’t had the revenue growth to make life easier for them.”

In fact, companies in the S&P 500 Index have seen five consecutive quarters of year-over-year sales declines for the first time since the third quarter of 2008, according to a March 11 report from data provider FactSet Research Systems Inc.

“What you’re seeing is an impressive expansion of profit margins and Ebitda growth, which is driven by cost cutting,” Boguslaski asserted.

But U.S. companies already went on an aggressive expense-reduction campaign after the financial crisis, so they can’t necessarily cost-cut their way out of their troubles now.

Furthermore, high M&A multiples are making it more challenging for PE portfolio companies to grow through acquisitions, he said, adding that many companies have turned to emerging markets for opportunities in recent years. The downturn in emerging markets, however, “is putting stress on U.S. companies that tried to expand overseas to grow,” he noted.

Companies attempting to grow into hefty capital structures may find themselves boxed in with no wave of domestic economic growth to ride, limited opportunities overseas, acquisitions out of reach, and costs already cut.

One way to evaluate how a capital structure matches up to financial results-think of it as market expectation versus reality-is to compare the ratio of enterprise value (debt, equity, minority interest and preferred shares minus cash and cash equivalents) to Ebitda.

Aswath Damodaran, a professor teaching corporate finance and valuation at New York University’s Stern School of Business, has assembled data comparing enterprise value-to-Ebitda ratios at 7,480 U.S. companies and 41,889 global companies across all major industries. As of January, the ratio for U.S. companies stood at 14.74, double January 2010’s ratio of 7.18, suggesting that U.S. companies have large shoes to fill. Globally, the ratios have gone in a different direction, settling at 12.96 in January compared to the last measurement point Damodaran disclosed, January 2012’s ratio of 18.44.

Looking at this data leads one to logically conclude that U.S. companies, including those in the portfolios of financial sponsors, are very expensive to buy right now. So just as the refinancing option has been closed, the M&A alternative may be close behind. Especially when it comes to PE firms being buyers. As debt markets start to freeze up, it becomes more difficult for private equity firms to line up deal financing-just as they face heightened competition from cash-rich corporations.

“Corporate buyers have become much more aggressive, and have had a greater ability to compete compared to private equity,” said Fitch’s Paladino. “They can outline and execute synergies, and pay multiples that now some financial sponsors can’t [pay] because of leveraged lending guidelines.”

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