A pickup in M&A and leveraged buyouts in the broader business world promises more underwriting and syndication fees for banks ... but there's some bad news.

Banks that help finance deals would have to add more high-risk assets at the same time that Basel III and the Dodd-Frank Act are tightening capital requirements. That reality will force banks to leave some of the extra business to nonbank rivals.

"These are constraints that are making capital more expensive for banks as compared to other aggregators of capital," said Richard Farley, a partner with the law firm Paul Hastings. "It's causing a lot of people to think that there may be nontraditional entrants into the leveraged finance market on the origination side: an insurance company perhaps, a hedge fund company, maybe a private-equity firm."

An increase in large-scale transactions will have a positive effect on underwriting banks, at least in the first quarter as they collect advisory fees and underwriting revenues

Banks that underwrite deals have to be prepared to hold some of that debt on their books, and that's going to get tougher as the year goes on. But if the brisk pace of leveraged buyouts, mergers and acquisitions continues deep into the year, banks would have to beg off or wind up with too many high-risk assets on their books, according to Fitch Ratings.

"Large U.S. banks, with balance sheets fortified, now have ample lending capacity, and they are likely to look more favorably on participation in deals," Fitch analysts said in a March 5 report. "In doing so, however, they may retain more risk on their balance sheets and run the risk that any rapid rise in interest rates and credit spreads will limit their ability to sell down risk and syndicate loans."

Banks encountered problems with large exposure to deals in 2007 and 2008, when a loss of liquidity in the markets wreaked havoc, the report noted.

Meanwhile, nonbank sources of funds are gathering strength. There is an estimated $342 billion in available private-equity capital that could fuel a surge in leveraged deal activity over the next few years provided the economy is stable, the Fitch report said, citing data provider Preqin.

The Basel III rules have yet to be finalized but would pose a major challenge.

Banks would have to include asset-for-sale debt securities among their Tier I assets. Previously banks did not have to take these holdings into account when calculating Tier I assets and capital ratios.

The requirement would pressure banks to hold fewer assets that are subject to interest rate fluctuations. As a result they would hold fewer loans and bonds on their balance sheets or hold them to maturity, limiting their ability to do new deals.

The players best positioned to step into the potential vacuum left by stressed banks in the leveraged finance markets are insurance companies, Farley said. Insurance companies possess the capital and back-office infrastructure necessary to originate leveraged loans or high yield bonds. He noted that hedge funds certainly have enough capital but are usually lean operations with fewer staffers than insurance companies.

Private-equity groups may take a greater role in the leveraged finance markets as well and have so far been among the most active alternative groups in the leveraged finance markets. Several private-equity firms already have credit market affiliates and have participated in lending. A move into originating and being a lead underwriter is within reach for these affiliates, and the private-equity firms have large pools of capital. LBO firm Blackstone has $4 billion available for mezzanine financing and recently obtained a license allowing it to underwrite securities. Kohlberg Kravis Roberts & Co.'s credit affiliate has had the most active bookrunning affiliate.

Firms in Europe have been first to increase their participation in the lending market, given that banks in the region have been more constrained. European private-equity firms CVC Capital Partners and H.I.G. Capital have participated in deals as lenders. Swiss LBO firm Partners Group recently closed on an $882 million investment program that has a mezzanine investment component.

Talent might flee to these alternative groups because banks cannot pay them as much, Farley said. Bonuses paid to bankers have been smaller than in years past because banks are coping with the aftermath of the Libor scandal and losses from other business lines. A large alternative lender with enough capital could easily woo talent away from banks, Farley said.

"The private financing potential on the buy side is greater than ever," Adam Vengrow, senior managing director and head of credit at Cantor Fitzgerald, said in an email. "[It's a] simple game of assets under management dwarfing investment opportunity in standard credit markets. Managers are looking for special situations that offer higher returns."

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