The era of lax lending is inflicting damage on one of its biggest perps, namely, investment banks. Wall Street firms, overeager to win funding mandates from private equity firms, agreed to terms that were very much in favor of the private equity firms. And now the LBO firms are holding them to their financing commitments, which in this market with no appetite for risky LBO paper, means the Wall Street firms are certain to take losses.
While I have no sympathy for the investment banks, this is a more serious matter than might appear. If market conditions do not improve, their losses are likely to be substantial (they are big enough that some firms have offered to pay the LBO firms’ breakup fees rather than make good on the financing) and in a falling profit environment, might even generate quarterly losses, which means a reduction of capital.
Whatever damage investment banks sustain from their stupidity is not enough to impair them by itself. But it means they will be ill equipped to sustain a second hit. And since investment banks have now become the central agents in financial intermediation, LBO-related damage could be the first blow of a one-two punch that creates systemic risk.
On a more mundane level, I anticipate that the bloodymindedness of the LBO firms will come to haunt them.
From the Financial Times:
Private equity groups believe they can force Wall Street banks to fund billions of dollars of pending takeovers in spite of the credit market turmoil by exploiting legal concessions extracted from the banks during the recent takeover boom.
Investment bankers and lawyers say some Wall Street firms are lobbying buy-out funds to cancel recently announced takeovers in the hope of avoiding big losses on the sale of the high-yield debt used to fund leveraged buy-outs.
Some banks are even considering picking up the break-up fees paid by private equity groups to companies when a takeover collapses.
But buy-out executives believe changes in the legal wording of deals provide them with guarantees that will enable them to close deals such as the $45bn purchase of the Texas utility TXU or the $27bn takeover of Alltel, the US wireless operator.
One private equity lawyer said: “The banks are coming to us appealing for help, saying that this is the time when relationships will be forged for the next 10 to 15 years. Private equity is responding by saying the same and reminding the banks they have a commitment to fund these deals.”
Wall Street’s likely failure to persuade buy-out groups to pull out of deals underlines the shift in the balance of power from investment banks to private equity firms during the record-breaking merger activity of the past few years.
Before the onset of the latest takeover wave four years ago, private equity firms and banks had “financing outs” in their agreements that enabled them to pull out without paying a penalty if capital market conditions deteriorated markedly.
But, as takeover activity intensified, buy-out firms, under pressure from corporate boards, gave up those escape clauses and forced banks to do the same.
Banks accepted the new conditions because they were eager to secure the lucrative financing associated with leveraged buy-outs.
Legal experts say the absence of those provisions makes it extremely tough for banks to pull out of deals unilaterally. “As a legal matter, it is very difficult for the banks to get out of these deals,” said a senior lawyer who has worked with banks and buyout firms
Other experts predict the tough conditions banks face will prompt them to re-impose conditions such as the “financing out” on future deals, restricting buyout funds’ debt-raising ability.
Buy-out executives argued that scrapping a takeover would be a huge blow to private equity groups that pride themselves on their deal-making ability, and would hurt their standing with future target companies.
“No one wants to be first to pull a deal,” one executive said. “If you do, it could be hanging over you for years. And other buy-out groups would use it against you.”