For Banks, a $300 Billion Hangover
By JACQUELINE DOHERTY
MONDAY, AUGUST 27, 2007
online.barrons.com
IN EVERY BUST THAT FOLLOWS A BOOM, embarrassing details emerge showing just how eager the players were to participate in the insanity. In the current bust, these revealing nuggets are buried in the lending commitments of some of the largest pending LBOs.
Investment and commercial banks, ranging from Citigroup (ticker: C) and JP Morgan (JPM) to Goldman Sachs (GS) and Merrill Lynch (MER), agreed to finance deals that might not close for six months, and at very low interest rates -- and without any escape clauses to protect them if market conditions deteriorated. Why? Because bankers were in hot pursuit of the next underwriting or merger-and-acquisition advisory fee. The private-equity shops knew it and they pushed through some of the most aggressive financing terms ever seen.
"The true leverage in this situation lies where it has for years: with Apollo, KKR, [Texas Pacific] and other financial sponsors," concludes Adam B. Cohen, founder of Covenant Review, which analyzes debt covenants for investors. "The banks are in a vulnerable situation, and may soon be holding a lot of undesirable loans with dismal mark- to-market prospects."
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In their bid to win LBO business amid the boom, lenders surrendered many of their exit options to private-equity shops.
Over the past three or four months, bankers have committed to lending LBO targets about $300 billion to fund buyouts. Their plan was to sell the loans to institutional investors. But demand for leveraged debt has evaporated in the recent market turmoil, even as yields on existing leveraged loans have risen.
So bankers now have two choices: sell the debt to investors at losses that could approach 10% to 12%, or hold onto it and hope the market improves. Most market players think the banks, when possible, will opt to take their lumps sooner, rather than later. For if they hold the debt, they risk a still-worse market or deterioration of the credit quality of the corporate issuer. They also would tie up capital.
Either way, earnings could come under pressure. Selling the loans at a loss would result in a writeoff, potentially cutting quarterly profits at some banks by as much as 15%. And holding the loans could hurt revenues, because the banks would have less ability to commit to new financings. That would likely dampen earnings growth from the red-hot pace of recent quarters, and crimp stock prices.
So, how did the banks wind up in this conundrum? Cohen, formerly a securities attorney with Latham & Watkins, explains that before 2004, bankers included clauses in their commitments allowing them to exit if the markets changed sharply. But as the LBO party got going, private-equity shops stopped allowing such clauses in their financing packages. Bankers who wanted the business went along. "The banks are contractually bound to fund on these commitments, come hell or high water," Cohen writes.
Once upon a time, bankers insisted on material adverse-change clauses that let them opt out if the LBO target's business or finances declined sharply. But now the banker needs to prove that deterioration at a company is worse than at others in its industry. So if a whole business -- say, mortgage-lending -- is hurting, the financing commitment still sticks.
Table: The Morning After
BANKERS' ABILITY TO CHANGE some of the terms of the financing to reflect a decline in the market also has been severely limited. Some recent deals allow bankers to increase the debt's coupon by only a quarter of a percentage point if the markets fall. That's little solace in today's market, where leveraged-loan spreads have widened by two percentage points. In the few deals getting done these days, bankers are requiring the flexibility to boost the coupon by one to two percentage points, says Adam Sokoloff, co-head of the financial sponsors group at Jefferies & Co.
The terms of the loans and bonds, known as covenants, were also looser in recent years. There were fewer maintenance tests. There was greater ability for the company to pay dividends to shareholders (instead of keeping the cash to improve its creditworthiness). The company could raise new debt that was senior to the LBO paper, and long-term assets could be sold to buy short-term assets. "In the aggregate, the terms and conditions of the 2006-2008 crop of leveraged loans bear very little resemblance to those of years past," writes Cohen.
The Bottom Line
Banks and investment banks gave private-equity firms low rates on LBO deals that hadn't closed. Now they -- and their shareholders -- may be stuck with this poorly priced debt.
Arguably the most vivid sign of the LBO bubble: The banks agreed to provide equity commitments, as well as debt. If a deal required $4 billion of equity, the financial sponsor might put up half and ask the bankers to provide the rest until the deal closed and the sponsor had time to shop around for other equity investors. In the Alltel buyout, Citigroup and Royal Bank of Scotland (RBS.U.K.) are each committed to invest $450 million of equity. And in the TXU deal Citi, JP Morgan and Morgan Stanley (MS) must each invest $500 million.
Deals do have breakup fees that are normally paid by the LBO sponsor to the acquisition target if the sponsor pulls out. Some have hoped that the investment banks would opt to pay the breakup fee to encourage the LBO sponsor to walk away from the deal. By doing so, the bank would potentially lose less money than it would by selling the debt at a loss. That could happen, but it's unlikely, because the bank would probably face lawsuits by the buyout target, Cohen warns.
It's nearly impossible to determine an investment bank's exposure to these financings, since multiple banks can be involved, and they use derivatives to lay off risk. But trying to sell $300 billion of debt into a spooked market where one of the top buyers -- issuers of collateralized loan obligations -- has disappeared, will be tough. And what follows the debt binge? The hangover.
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