In response to concerns that the recession could further damage businesses, some investors are seeking ways to help banks reduce their exposure to commercial loans.
Private-equity firms such as Midwest Mezzanine Funds in Chicago and Key Principal Partners LLC, a Cleveland company, are gearing up to help buy down the loans of middle-market customers in exchange for injecting subordinated debt. The firms expect more banks to turn to them as a way to shore up their balance sheets without losing their customers.
Many banks are carrying problem residential construction and development loans. As the economy weakens, this credit deterioration is spreading to other commercial real estate sectors, as well as commercial and industrial loans.
David Gezon, senior managing director at Midwest Mezzanine, said buyout firms can help banks stanch the bleeding among their business borrowers.
"This is a good option to writing off loans, which hurts capital, or selling the loans at a loss," he said. "Banks are happy, because the loans would be fully collateralized and amortized," and the deals can provide banks with a good source of funds.
Midwest Mezzanine has put a $211 million fund to work primarily for financing buyouts, expansions and recapitalizations by middle-market business customers, and it is considering using the money to help the customers pay down their bank debt, Gezon said. The firm is not looking to do so until the economy has bottomed out and it can estimate a borrower's future earnings and cash flow. Still, it is getting three to four calls a day from bankers, so it will likely start making deals by the fall, he said.
John Sinnenberg, the chairman of KPP, said mezzanine capital provides an alternative for business owners who do not want to give up majority control of their companies. Unlike other buyout shops, mezzanine capital firms typically provide noncontrolling investments, or "junior" capital, such as subordinated debt, preferred stock or common stock.
Phil Curatilo, the firm's chief marketing officer, said that helps banks retain long-standing customers that are struggling with slow cash flow but are likely to revive once the economy improves.
"These banks aren't looking to dump these businesses from their portfolio. They just want to reduce their exposure and maintain the good relationships they've had with them," he said.
KPP would draw from a $500 million fund, its third, to purchase commercial loans. Half the money for the fund came from KeyCorp.
Jeff Davis, a senior vice president and director of research at Howe Barnes Hoefer & Arnett Inc., said the strategy can benefit banks by keeping a loan performing or a marginal credit from being classified, though commercial customers may pay a high price.
"There may be something a little quirky about the business, or it might be in an industry that the bank has more exposure than it wants to, such as trucking or hotels," he said. "But for the borrowers, it's expensive, because the credit markets are all about risk-adjusted pricing, and mezzanine funds target a high rate of return."
Midwest Mezzanine is seeking a return of 14% to 18% on its investments in bank customers; KPP is seeking returns of roughly 20%. Subordinated debt instruments typically have terms of five to seven years, typically with no amortization of principal until maturity.