America's regional banks, looking for ways to increase their margins without excessive risk, are more eager than ever these days to take part as lenders in leveraged buyouts.
With competition squeezing margins on traditional forms of lending, banks are finding LBO lending attractive. It is not only lucrative, but it also has "sizzle," making it especially appealing to regional banks ambitious to become "players."
But bankers should be aware that LBO lending is very different from "plain-vanilla" corporate lending. They should understand that the quality and track record of the buyout's sponsor - not just the strength or asset base of the business being bought out - are critical to a buyout's long- term success.
In other words, they should look before they lend.
Regional banks participate in LBO lending in various ways. A few banks come into the process as advisers to a local business, whose owner wants to sell, partially cash out, or arrange a transition to new management or ownership. More get involved as participants, and sometimes co-lenders, in a larger bank's loan. Others may organize and lead a syndicate of lenders. If the deal is small, a regional bank may be the sole lender.
However they get in, what they need in the long run is to be able to get out - with the principal returned, with the interest paid, and without a black eye in their community.
Having been in the LBO business for some years, let me share some observations that may help banks to achieve those positive, long-term results. I would describe these as "the Five C's of LBO Lending."
Bankers have long been accustomed to "the Three C's of Lending" - character, capacity, and collateral, the fundamental building blocks of commercial lending. Is the borrower the sort who will repay the loan, does he have the means to do so, and can he pledge sufficient assets to protect us if he doesn't pay?
The Five C's overlap a bit, but are somewhat different. They are: Constructive policies, commitment, capacity, character, and control. How well the sponsor stacks up on these measures, based in large part on the firm's prior record, may indicate how comfortable the bank will be with its loan a few years down the road.
1. Constructive policies are a tip-off. Buyout firms come in many shapes and sizes, with different styles and strategies. The firm's individual approach to the business may send out strong signals regarding a deal's probable impact on the local community - and on the bank's customers.
Are the sponsor's policies and history constructive or destructive?
Does it typically break up acquired companies, selling off their parts to recoup its investment? Or does it seek to build and enhance the businesses it buys? Plant closings hurt the bank and local business, causing bitterness and pain in the community. But revitalized businesses can grow, add jobs, contribute to the community - as well as repay debt and generate consistent profits.
2. Genuine commitment is important. Commitment is fundamental to a positive outcome. Is the sponsor committed:
*To the company it is acquiring, determined to help it succeed and grow?
*To the lenders, so that they will get paid, even if circumstances turn adverse? (What has the LBO firm done in the past when circumstances have changed?)
*To dealing fairly and honestly with the employees, even if some must be laid off?
Does the sponsor intend to give employment contracts to management or to the senior staff who are retained? Will they be encouraged to be stockholders? Will the new ownership install, continue or expand bonus or profit-sharing plans to reward and motivate employees?
3. Capacity makes a difference. Capacity - the sponsor's financial strength - determines whether the sponsor can actually do what it promises. Does the sponsor have deep pockets and - equally important - is it willing and able to support an active growth strategy? Has it done so in the past? Will it put up additional capital, if needed, to take advantage of a growth opportunity, fix a problem or deal with a crisis?
If the new owner is a limited partnership, does the partnership agreement enable or allow the sponsor to make an additional investment?
4. Character is key factor. The sponsor's character is important. Is the sponsor a company the bank will be comfortable doing business with? What is its reputation in the marketplace? How are the sponsor's principals regarded? What are the reputations of the partners or investors? Will they be active in the business? Are they people of ethics and integrity, experience and acumen?
5. Control is fundamental. Control is the essential underpinning of an LBO. The sponsor must control the acquired company - usually with at least a majority interest - in order to carry out the strategy on which the acquisition was premised, enforce discipline and change, and get management to make and implement hard decisions.
A sponsor that gets high marks on the Five C's test - assuming it has analyzed the company and its markets correctly - should be able to make its new acquisition prosper. That will be good for the bank, the business, the employees, the community and the investors.
Even if markets sour, a positive growth strategy carried out with integrity and skill is likely to gain the support of employees, lenders, suppliers, customers and the community, helping it survive until conditions improve.
I am confident that a report card on the Five C's can be a good measure of the desirability of working with the LBO sponsor. As important, the report card can also be a good leading indicator - for a lending bank and everyone else involved - of whether the long-term result of an LBO is likely to be positive.
Mr. Harlan is president of Castle Harlan Inc., a New York-based private merchant bank.
