The funny thing about the oft-repeated George Santayana saying, “Those who cannot remember the past are condemned to repeat it,” is that it is generally applied to historical events, like the folly of launching an attack on Russia that might extend into the winter. But these days, in the financial markets, with so many people retiring or sidelined before they reach 45, people seem unable to remember and learn from what happened a mere generation ago.
Financial firms seem to be in agreement that equity bridge loans, made to private equity firms who want to avoid bringing equity partners into their deals, are a bad idea and that they are inadequately compensated for the risks. That’s actually different than the perception the last time we saw this movie, around 20 years ago at the end of the last big LBO wave in the 1980s. Then the deals were priced differently and investment banks found them to be attractive financially but still hugely risky. And indeed they were. A single hung deal, Ohio Mattress, forced First Boston to seek capital from its investor Credit Suisse, eventually leading to a takeover.
So remember that lesson: it takes only one bad deal to inflict considerable damage. Yet, even though firms carry on as if they are being forced to pick up nickels before a steamroller, the reality is that they are rationalizing these deals in terms of the profitability of the entire relationship with top private equity funds. Indeed, a Wall Street Journal story last month, “Regulators Eye Banks’ Risk in Buyout Lending,” noted:
Regulators see signs of that in LBO lending, particularly in what is known as “bridge” financing, or the temporary credit that serves as a stopgap between the buyout and longer-term financing.
LBO loan volume hit $121 billion last year, compared with $31 billion in 1998, the peak of the previous cycle, according to Standard & Poor’s Leveraged Commentary & Data. Volume this year has reached $88 billion, more than double the year-earlier period. Meanwhile, interest-rate spreads have fallen to their lowest levels ever, and loan restrictions have been loosened.
“There are some significant risks associated with the financing of private equity, including bridge loans, [and] we are looking at that,” Federal Reserve Chairman Ben Bernanke said in response to questions at a Chicago conference yesterday. “I urge banks to closely evaluate the risk that they’re taking not only in the context of a highly liquid, benign financial environment, but in one that might conceivably be less liquid and benign.”
Goldman, a notoriously profit-minded firm (and one that was chary of the bridge loan business the last time around) is reportedly pulling back from these deals. Would you go where Goldman is disinclined to tread?
The recent popularity of a risky private equity financing agreement, known as an equity bridge loan, is raising concerns among analysts, regulators and even the bankers who arrange them.
Equity bridge loans allow private equity firms to get investment banks to share in the cash payment on deals. Such loans are great for buyout firms wanting to pursue takeovers without joining forces with competitors, but carry huge risk and skimpy pay-offs for the investment banks.
While this type of lending has been around for decades, the size and frequency of the loans has risen to the point where Goldman Sachs
has told its mergers and acquisitions staff to avoid them, according to a banker who works there. Goldman declined to comment about its policy.
The Ontario Teachers-Providence Equity Partners group pursuing Canadian telecoms group BCE Inc.
is asking investment banks to pony up a roughly $4 billion equity bridge, leaving the banks on the hook for about $800 million each, according to two people involved with the deal.
That’s a staggering amount of exposure given that just last year, the equity bridge commitments for buyouts of media companies Univision and Clear Channel Communications Inc., which ranged from $100 million to $350 million, were deemed large, according to sources involved with the deals.
“Equity bridges are a really bad business,” said an investment banker who arranges private equity deals. “You have a very small amount of reward for a huge risk. But people are doing them because it’s forced on them in terms of being competitive. The pain is going to be immense if one of these bridges falls apart.”
The best-case scenario is that the investment banks quickly sell the equity exposure to other buyers. But even then, banks typically earn only a 1.5 percent return on the loan. That means for risking $500 million, they earn just $7.5 million.
The worst case is that banks can’t sell down the equity. Then they are left holding the bag, in some cases with hundreds of millions of dollars in exposure.
Chief executives, credit officers, strategists and investment banking heads are all signing off on these loans. Bankers interviewed for this article say a tremendous amount of time is spent dissecting deals before handing over a big check. Some say no to equity bridges.
But bankers also admit that the private equity players — whose deal frenzy is throwing off billions of dollars in fees for Wall Street — call the shots, and equity bridges are simply the price you pay to play with them.
“It concerns us every day,” said JP Morgan global equity strategist Abhijit Chakrabortti, referring to the rise of equity bridges.
Chakrabortti, speaking at the Reuters Investment Outlook Summit this week, said while JP Morgan keeps a close eye on these loans, he does not see any near-term pull-back that would hit the leveraged buyout (LBO) market. Private equity firms buy and sell companies, borrowing most of the money to finance the deals. Frothy debt markets have fueled the current LBO wave.
“You always need a catalyst and we’re not convinced that yields or the interest rate outlook is at that level where we’re going to get that hit,” he said.
Indeed, LBO deals are still being pumped out with no end in sight. But the growing prospect of interest rate rises has led some analysts to believe the frothy debt days are numbered.
The heavy borrowing and risky financings fueled by cheap debt have not escaped the attention of U.S. Federal Reserve Chairman Ben Bernanke.
“There are some significant risks associated with the financing of private equity including bridge loans,” Bernanke said last month. “We are looking at that.”
Equity bridge loans appeared in the late 1980s but then went dormant, for the most part. They became popular again late last year when private equity firms started pursuing larger companies on their own, or with one other LBO partner.
Citigroup and RBS Securities arranged an equity bridge of $450 million in a $25 billion LBO of wireless company Alltel Corp., according to a proxy filed on Wednesday.
Morgan Stanley, Citigroup and JPMorgan have offered a $1 billion equity bridge in an LBO offer for Texas utility TXU Corp.
An equity bridge was also part of a proposed $17.1 billion buyout of casino company Harrah’s Entertainment Inc.
“It’s just further evidence that the private equity folks are calling the shots,” said Tom Marshella, a managing director in leveraged finance for credit-ratings agency Moody’s Corp.
“It’s astonishing the degree of risk they’re able to lay off, including underwriting the equity. I haven’t seen
anything like this in the (11 years) I’ve been involved with leveraged finance.”