In Constraining Equity Investing, Regulators Follow a Myth
Casting a pall over the 1990s is the spectre of the exposure of highly leveraged transactions to danger from the recession.
As some of the best-laid plans of buyout sponsors have started to unravel and the prospects of further troubles loom, questions have been asked concerning the proper regulation of the banks' roles in buyouts and about the proper and prudent conduct of their business.
With the benefit of hindsight, it is fitting to review the banks' real role in the buyout phenomenon. For there are myths to be dispelled if the legacy of the late 1980s is to be mitigated.
Loans and Equity Investment
It was, and is still, commonly said there exists one fundamental and crucial difference between lending - even deeply subordinated leveraged buyout lending - and real equity investing.
The difference is said to be this:
With a loan, a bank's entitlement is contractually specified. In the equity game, investment returns are far from contractually specified. Rather, they are wholly contingent upon the future performance of the investee and the vagaries of the stock market.
Widely Accepted, but False
The idea that this "crucial difference" makes lending a qualitatively different kind of activity from equity investing is, however, a pernicious myth. For it involves confusing entitlements with returns.
That a bank's entitlement pursuant to a loan is a specified percentage only means that it may be reasonable to assume that percentage amount will be the single most probable return realized over the life of the loan. It eliminates entirely any possibility of a maturity return in excess of that specified percentage.
But it is certainly no guarantee against a lesser return being realized, for the return is wholly contingent upon a maximum level of performance being turned in by the borrower.
Different Category of Lending
The possible returns to be realized on a conventional loan lie within a far narrower range than do those returns on an equity investment.
But LBO loans are far from conventional. They entail a much wider range of possible returns than is associated with conventional banking assets.
This is the respect in which LBO loans resemble equities investments.
And as LBOs are being recapitalized or reorganized, with lenders taking losses alongside the equity, the significance of this fact is sinking in.
The "pernicious myth" appears to have been embraced by regulators, bankers, and investment bankers alike.
Regulators have, for over half a century, kept commercial banks away from many forms of equity investing.
Bankers have, meanwhile, cultivated credit analysis as an arcane hybrid of science and art to the point where they admit common equity evaluation is as alien as flight to the ostrich.
And investment bankers have been only too eager to side with both the regulators and the commercial bankers, for it has meant a useful sinecure performing those merger and acquisition and "merchant banking' functions that they argue could not be adequately performed by their deposit-taking relatives.
For Another Way
It is high time to change the status quo. The economic and thus the banking environment in the United States has changed crucially.
Many of our largest corporations are today carrying debt loads that either have proved or may someday prove to be overly burdensome. It is time for the subordinated lenders' de facto equity-type interest in these situations to be explicitly acknowledged.
To the regulators must fall responsibility for removing the rules and regulations which embody the "pernicious myth". These rules and regulations are barriers to the exercise by commercial banks of their proper rights and initiatives as real owners of corporate America.
It is not equity investments from which the banks should be diverted, but imprudent investments of any kind.
And how much less imprudent would it be for banks to invest in the equity of conservatively capitalized corporations, rather than in HLTs?
Mr. Eades, a former investment banker, is a professor at Pace University and author of "Options, Hedging, and Arbitrage," forthcoming from Probus Publishing.