LB0s, Who Will Be Left Holding the Bag?

This is a very important analysis of one crucial weak spot in the whole private equity setup. When the deal is started, the takeover artists borrow money from the banks — a bridge loan to pay off the shareholders. Then the LBO and the banks sell bonds to the public to pay off the bridge loans.

The banks make hefty fees. The people who buy the bonds also profit royally — so long as the bonds are paid off. The problem is that the companies are so loaded up with debt that they may have difficulty in paying off the debt.

Now the people who are supposed to buy the bonds are catching on, possibly leaving some of the banks holding the bag. Will you cry for them?

Banks on a Bridge Too Far? As Risk Rises in LBOs, Investors Start to Balk; Warning From Overseas


June 28, 2007; Page C1

The nation’s largest financial institutions have spent the past year relying on robust capital markets to offset woes in their retail-banking operations. Now, that big revenue stream may be starting to dry up.

A sudden retrenchment in debt markets is likely to nip at profits at the big banks that have been financing the leveraged-buyout boom around the globe. The latest deal bonanza, in which private-equity firms buy public companies and load them up with debt, has created several new financing techniques that mint money for the banks, but can also leave them holding more risk.

A day after investors recoiled from a $1.55 billion debt offering by U.S. Foodservice, Vancouver-based Catalyst Paper Corp. yesterday pulled a $150 million bond offering that already had been cut from $200 million.

Bankers said investors have grown wary of debt deals that offer few financial protections and yields that don’t reflect potential risk.

For J.P. Morgan Chase & Co., Citigroup Inc. and Bank of America Corp., the biggest players in the leveraged-loan business, a slowdown in deal financings comes as they grapple with difficult issues. Among them: a tricky interest-rate environment that makes it less lucrative to make loans, a slowdown in mortgage and home-equity lending, and fierce competition to acquire deposits, even as banks are still struggling to assess the fallout from the turmoil in subprime housing.

Banks won’t “lose money, but what will happen is that they won’t make as much and earnings may decline,” said Ganesh Rathnam, a banking analyst at Morningstar Inc. in Chicago.

As they have raced to finance leveraged buyouts, the banks have also steadily taken on more risk. Although much of it is typically parceled out to investors, the banks can be left holding the bag, as happened when investors balked at the U.S. Foodservice deal.

In the U.S., so-called covenant-lite deals accounted for about 26% of first-quarter deals versus 4.6% in European leveraged-loan issues. The pace began to sharply increase in Europe in March, according to Bank of America research. The “cov-lite” deals — where a bank’s covenant protections are weakened — have been a result of the cheap financing, allowing borrowers to reduce financial covenants that typically require borrowers to meet financial hurdles on a quarterly basis, the report noted earlier this week.

In particular, regulators are expressing concern about “equity bridge loans” in which private-equity firms ask their banks to provide stop-gap financing for some deals. The loans, which carry high interest rates, last from three to 24 months and are repaid once the sale of below-investment-grade, or junk, bonds has occurred.

So far this year, banks have provided $33.38 billion in bridge loans to leveraged-buyout deals, more than double last year’s $12.87 billion, according to Reuters Loan Pricing/DealScan. The volume is the highest since the LBO heyday 20 years ago, when $48.14 billion in bridge loans was issued in 1988.

Of the banks, Citigroup, Deutsche Bank AG and J.P. Morgan have arranged the most bridge loans for leveraged-buyout deals this year.

Regulators expect to take another look at guidance they issued in 2001 on leveraged lending to see if it still fits. At the time, banks kept most leveraged loans on their balance sheets, and regulators thus expected them to consider the borrower’s ability to repay principal, not just interest. Banks now typically distribute their loans to institutional investors, so regulators say they may need to consider different criteria. It may be less important for a bank to consider the borrower’s ability to amortize a loan, and more important to weigh the “reputational risk” that a loan it sold to investors goes bad, or “pipeline risk” — when adverse financing conditions force it to keep a loan on its balance sheet rather than distributing it.

A report this month by the Bank for International Settlements said, “The fact that banks are now increasingly providing bridge equity, along with bridge loans, to support the still growing number of corporate mergers and acquisitions is not a good sign.” It went on to say: “A closely related concern is the possibility that banks have, either intentionally or inadvertently, retained a significant degree of credit risk on their books.”

Overseas Warning

The warning bell is also sounding overseas, where a report by the European Central Bank notes that while banks claim they used careful credit analysis, “it cannot be excluded that such pressures could encourage banks to compromise their due diligence and loosen their credit standards should rapid growth in the market continue.”

The big banks typically don’t provide details on revenue or fees derived just from the lucrative leveraged loans. Still, it is clear that the wave of financings has made a big contribution to the bottom line. Last year, for example, J.P. Morgan earned $2.7 billion from all debt-underwriting fees, up 37% from 2005. By comparison, the bank generated $1.2 billion in equity-underwriting fees and $1.7 billion in merger-advisory fees. So far this year, J.P. Morgan is the top arranger of U.S. leveraged loans, according to Thomson Financial, putting together $123.6 billion of deals in 234 transactions.

In recent weeks, some high-level bankers privately have started to condemn the practice of providing bridge loans, although most firms still find it difficult to turn down a lucrative deal from a client with deep pockets. And Kenneth D. Lewis, chairman and chief executive of Bank of America, has repeatedly said that the bank is starting to turn down deals and heed investor pushback on thin pricing and lack of protection.

So far, analysts say it appears the banks are well-capitalized to sop up their exposure. In most cases, they say, deals will get restructured on terms investors will swallow, significantly reducing the originating bank’s risk.

Banks are already expected to start building reserves to cover potential bad loans. Ultimately, says Bear Stearns banking analyst David Hilder, a loan-market shake-up could be just what the banks need. “If [the current situation] actually results in tighter covenants or tougher underwriting or more equity in the loan structures, it could actually be good for the banks because it would diminish the likelihood of future loan losses,” he said.

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