Private equity firms warned that high debts are hurting buyouts

Private equity groups came under renewed fire yesterday as a top credit ratings agency accused them of being too quick to issue debt after buying out firms to pay themselves hefty dividends.

Credit ratings agency Standard & Poor's said the trend by private equity investors to fund big payouts to themselves with bank loans or corporate bonds raised against their portfolio companies was chipping away at firms' credit quality.

S&P is concerned that raising the debt on a bought-out company's balance sheet is becoming a quick and easy way of getting a return for private equity firms. S&P credit analyst Sucheet Gupte said: "They're sometimes called 'drive-bys' because they can be that opportunistic."

The private equity sector, which has grown rapidly in recent years, traditionally made money by buying a company, overhauling its business away from the public glare and then selling or floating it for a profit.

But S&P cautioned in a new report that private equity groups were increasingly taking on more debt at the bought-out firms to get returns - known as dividend recapitalisations.

The ratings agency cites Hertz as one firm whose balance sheet has been dented in such a scheme. A consortium of private equity investors bought the car rental company from Ford last December. Just six months later the new owners used bank loans to extract a $1bn (£526m) dividend, close to half their original cash investment.

A recent UK example of a leveraged recap deal involved department store chain Debenhams, bought in 2003 by a consortium of CVC, Texas Pacific Group and Merrill Lynch Private Equity. The investors have made three-and-a-half times their investment in little more than two years.

While some private equity-backed firms can generate enough cash to cope with their debts, others cannot. S&P said about 6% of the loans used in recent dividend recaps have been defaulted on.

S&P says that so far this year there have been more than 60 recapitalisations worth a total of more than $25bn. The ratings agency says aside from the lure of dividends, investors' hunger for higher yielding bonds is also to blame while banks are happy to reap big fees from loans.

For their part, private equity groups say debt is an effective source of capital as long as interest rates remain low and the economy stable.

"It's not in anyone's interest to over-leverage," said Peter Linthwaite, chief executive of the British Venture Capital Association. "Private equity firms don't go into a deal with the idea of pushing as much debt as possible into it and saying 'oh well if it goes wrong it goes wrong.' Most of their return still comes from when they sell the business."