I really wanted to lay off private equity for a bit, but the news flow keeps getting in the way.
Today, the New York Times’ Andrew Ross Sorkin has a detailed story on a troubling, and apparently well-established practice among buyout firms: that of making sure that the lenders to their deals don’t have the benefit of independent legal advice. No, I am not making that up.
As we’ll discuss in due course, I suspect the reason for bank complacency is analogous to what took place with securitization: they do not think they have to care much about corner-cutting on risk because they don’t anticipate being long term holders of much, if any, of these loans. I’d love people current on how these loans are sold down to weigh in; the fact that this practice is not well known outside the industry and that Sorkin found sources to be closed-mouthed (despite also trying to maintain that this practice was no big deal) suggests that the ultimate owners of these loans may not always be aware of this dubious practice. It appears to be yet another case of the “originate and distribute” model leading to the ability of the originator (in this case the lead lender or lenders) to escape liability despite its assumed role as quality-vetter.
Sorkin’s piece is solid. Key sections:
Over the last several years, a new, insidious relationship has quietly developed between the nation’s largest private equity firms, the banks that lend them billions to fund their buyouts and the law firms that advise on these deals.
Historically, when a bank, like JPMorgan Chase, made a loan to a private equity firm planning a big acquisition, like the Blackstone Group, the bank would hire an outside law firm to scrutinize the loan and the transaction.
That made a lot of sense: Loans made to finance private equity deals are some of the riskiest because they typically involve a lot of debt…
Instead of allowing a bank to hire its own lawyers to vet a potential loan, many large private equity firms — Blackstone, Apollo Global Management, Kohlberg Kravis Roberts and Carlyle Group among them — now regularly require the banks to use a specific law firm that they designate, hence the term “designated lender counsel.” The private equity firms pay for the law firm’s services, too.
Think about it this way: It is, in effect, the equivalent of your employer giving you an employment agreement and telling you that the only lawyer who can look it over is the one the company has retained.
Bankers and their in-house lawyers privately complain that the private equity firms are assigning them law firms that have little allegiance to them and might not necessarily have their best interests at heart. But given the pressure to secure these big loan deals — which can be worth hundreds of millions of dollars in fees — few are willing to publicly criticize the practice.
As Sorkin also points out, the Fed has been sufficiently concerned about bank exposure to buyout loans that it has put constraints on them, yet has been asleep at the wheel as far as this not-so-new development is concerned.
And his uncharacteristic tone of alarm is fully warranted. While on small venture deals, the entrepreneur and funder will sometimes agree to use the same counsel, particularly when the lawyer made the match by virtue of having a relationship with both sides, heretofore it would be well-nigh unheard of for a sophisticated party to agree to use a lawyer picked and paid for by the other side. It’s stunning that the participants are trying to pretend that the lenders have adequate representation.
So why are the banks not up in arms? Here is where the piece gets disingenuous, not because Sorkin is being disingenuous per se. He’s just repeating the lines that private equity kingpins have successfully honed as to why their victims agree to go along: “They agreed to be marks”:
Indeed, when I called private equity firms — representatives from which all refused to speak on the record about this practice — they all said that if the banks were really that upset about it, the firms would have already heard complaints.
But that ignores the influence that private equity firms have over the banks, and the banks’ lack of incentive to speak up.
“The borrower has a lot of muscle, a lot of leverage,” Robert Profusek, a partner at the law firm Jones Day and one of the few lawyers who would speak on the record about this issue, said of the private equity firms. “When you’re competing for business, you’re not going to turn it down because you can’t use law firm A rather than law firm B.” (Mr. Profusek’s firm does some work as designated lender counsel.)
Let’s unpack why this “no one has complained” (or more accurately, “not enough people to matter have refused to do business with us over this issue”) excuse is rubbish. All you need to do is look at the incentives.
The banks that are the lead lenders, meaning the ones who historically did due diligence on the deals, which included hiring counsel to review and negotiate terms, are not significant ultimate owners. I’m not current on industry norms, and in over-the-counter markets like leveraged loans, it’s hard to get good data (you have problems of definition of the universe as well as getting private parties to supply data). If readers know of any good academic studies or recent articles on who are the end investors in leveraged loans, please pipe up in comments. Nevertheless, the major investor types include:
¶. Collateralized loan obligations
¶ Private equity credit funds
¶ Other banks, presumably foreign
¶ Retail leveraged loan funds
¶ Junk bond funds (in a major disclosure fail, the fine print of these funds typically allow for considerable investment in loans, which are not very or not at all liquid, when investors have the impression that the fund assets are securities)
¶ Hedge funds
¶ Direct lending funds. This appears to overlap with what some might call “private equity credit funds” so you can already see the difficulty of parsing data as bankers sell old wine in new bottles
And of course, another problem with this list is it mixes product types with investors. CLOs are often bought by credit funds, but they can also be purchased by hedge funds, and I would expect foreign banks to be a target market too.
But you get the general idea. In most cases, the lead lender(s) is not likely to wind up holding much, if any, of the loan.
Even when banks do wind up eating their own cooking, the incentives of staff conflict with the incentives of the institution. Even though regulators have pressured banks to have staff get more of their compensation tied to long-term results, that has happened more in what regulators see as the high-flying areas: trading and investment banking. While top leveraged lenders, like the recently deceased Jimmy Lee at JP Morgan, are big honchos, in most banks, they sit on the traditional lending side. Thus there is reason to doubt how much they are subject to the investment banking regime of having comp deferred or take the form of, say, restricted stock.
In other words, these loans pay big up-front fees. The lending side of banks find these tempting even though they ought to know better. Those fees bolster quarterly earnings and department/division revenues in a big way. That means that some of those revenues will wind up in bonus pay packages too.
Now you might say, “But what about the end investors? Surely they do their own due diligence?”
In short, no, or not much. This gets back to a myth we have been trying to debunk, that of the “sophisticated investor”. CalPERS is a sophisticated investor. It has invested in private equity credit funds. The terms of those funds are as one-sided as private equity deals are generally. CalPERS is along for the ride that the general partner has put it on. As we’ve discussed at length, these investors have very limited oversight once they’ve committed to a fund. So they do no due diligence whatsoever on the loans these funds make. Their “due diligence” is limited to that of the fund manager.
And even when the lenders actually are banks or end investors like insurers participating in a loan syndication, there is ample evidence that due diligence is sorely wanting. For instance, a contact said that in the mid 2000s, leveraged lenders in London distributed offering documents via a web-based tool. It was an open secret that the information was often downloaded long after many of the stuffees, um, investors, has signed up. In other words, it is all too common in this market that stuffees take down loan participations without doing much (or any) analysis.
Sorkin ends on this note:
Of course, the choice of which law firm will represent a bank on a big private deal will not lead to the next financial crisis. But if regulators care about reducing risk and eliminating conflicts in the markets, this practice might be a good one to examine.
While this is technically accurate, this fact set points to a more troubling conclusion: the fact that lenders are accepting this indefensible arrangement is a sign of a lack of due diligence. Worse, the general partners have strong incentives to do everything they can to weaken already lax due diligence even further, since it leads to underpriced credit risk, which in turn lets them do deals on more attractive terms. In case you missed it, the last crisis resulted from underpriced credit. So while this legal representation issue is not a systemic risk issue per se, it is a symptom of practices that combined do increase systemic risk. And by minimizing them individually, the private equity industry hopes to blind investors, regulators, and the broader public to this pathology.