One of the most lucrative transactions in investment banking has suddenly become a very expensive headache for US and European banks. They’re facing big potential losses from about $80 billion in acquisition debt that they promised to raise to facilitate mergers and leveraged buyouts when financial conditions were better. The likes of Bank of America Corp., Credit Suisse Group AG and Goldman Sachs Group Inc. could each face a $100 million hit on the so-called hung debt from just one such financing deal alone. It’s not the first time banks have been burned when what’s known as committed financing turns sour quickly. Banks are better able to withstand such losses now than they were in the financial crisis of 2008. But as happened before, the experience appears to be contributing to a chill in deal-making.
1. What kinds of deals are turning bad?
These are financings for mergers and leveraged buyouts (acquisitions loaded with high levels of debt) that involve what’s known as leveraged finance, a term that refers to the debt of companies that are rated below investment grade -- so-called junk. Banks once used to make such loans directly but now they operate as a middleman helping such companies raise capital from investors. This approach has become increasingly important for banks and “arranging” such debt accounted for about a third of investment banking revenue in recent years. But a crucial part of the process involves banks acting in effect as a backstop lender, offering committed financing -- and in doing so, putting themselves on the hook for the money needed to make a deal go through, ideally briefly.
2. How does committed financing work?
Take a close look at a merger announcement, of the kind issued when corporation A touts that they are purchasing corporation B or private equity firm C is taking over corporation D. Below the headline purchase price, there’s often a section detailing the debt used for the acquisition. That section is where Wall Street banks are listed as providing “committed” financing. Much hinges on that one word “committed,” as it is a legal obligation that the banks make to a potential buyer in a leveraged buyout. This commitment is a critical part of the M&A world since it reassures target companies that the deal won’t fall through because of a buyer’s inability to raise the debt needed to make the purchase.
3. What’s at stake for the banks?
Banks are taking a risk when they provide committed financing because they are making an obligation now to sell the debt in the future. It’s called a fully underwritten financing, meaning they can’t nix their promise in the event that market condition changes. While the promise of future financing is supposed to keep a deal moving forward, banks can get stuck with the debt if interest in such bonds and loans dries up while the transaction is in process. If a bank opts to fund and keep the debt rather than sell at a loss, that’s called a hung deal. For the risk, these deals command fees ranging from 2 to 2.5% of the total size of the debt package.
4. Are hung deals a big deal?
On Wall Street, many veterans still recall the episode that became known by the phrase “the burning bed.” In the late 80s, a hung financing felled First Boston, once ranked as one of the premier investment banks in the US. First Boston had provided $457 million in the form of a bridge loan for the buyout of the mattress firm Sealy, an amount that represented 40% of the bank’s equity capital. When the buyout debt market collapsed shortly afterward it was stuck with the loan. The bank required a bailout from part owner Credit Suisse, which already had a 44.5% in First Boston and which completely took it over in 1990. Hung deals happen individually in good times and bad when a bank makes a call on a company that investors turn out to disagree with. But they happen en masse periodically when market sentiments change swiftly. After the financial crisis of 2008, banks had more than $200 billion of hung debt on their balance sheets, mostly for leveraged buyouts. When subprime mortgages collapsed, the massive losses that banks experienced on committed deals contributed to the balance sheet weakness that eventually led to government-led bailouts for many of them.
5. What caused the trouble this time?
In this case, high inflation has persisted longer than banks had predicted at the end of last year and the beginning of this year. That means the financings were underwritten before it became clear that most central banks, including the US Federal Reserve, the European Central Bank and the Bank of England, would lay plans for aggressive interest rate hikes. As a result, investors are now demanding significantly more to lend to companies. Yields in the investment grade bond market, high-yield bond market and leveraged loan markets have all more than doubled since the beginning of the year. Since underwritten deals oblige banks to provide financing at agreed upon terms, they are responsible for making up the difference. While banks can agree to borrowers’ demands to change pricing and terms -- to provide what’s called flex or cap in Wall Street parlance -- they don’t have enough wiggle room to match what lenders can get elsewhere.
6. How big a problem is this for markets?
US and European banks are on a sounder footing than they were during the Great Financial Crisis. The rules that forced them to increase their capital levels also make it hard for them to hang onto junk debt, making it more likely that they’ll sell it at a loss. While that will be painful, they should be able to absorb the hit to their capital. But if the past is any predictor, they will be chastened and likely less willing to underwrite similar deals, at least for a while. Deals are likely to dry up, both because buyers and sellers are less interested in M&A deals and because banks are more wary about funding them. Walgreen’s attempt to sell its UK drugstore chain Boots was partly foiled by challenges that potential buyers had in getting banks to underwrite the financing. Of course, in some ways, reducing the market’s appetite for debt-fueled deals is in keeping with the Fed and other central banks had in mind when they raised interest rates and began to tighten financial conditions.
• A Bloomberg article on the potential for big losses on hung debt.
• An article on how the risks for banks are crimping the credit needed for acquisitions.
• A 2008 article on how banks worked off a $200 billion pile of hung loans from deals that soured in 2007.
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