The current boom in private equity is, if nothing else, more evidence of the financial community’s persistent ability to call a thing that which it is not.
The money that has flowed into the sector in recent years has supported a range of investments and deals that are far more notable for the debt they support than the equity behind them.
The debt-laden mergers and acquisitions that have flooded the market are politely referred to as private-equity transactions, but in a different era — before junk bonds, hostile takeovers, Michael Milken, and Ivan Boesky — people would have been satisfied to call them leveraged buyouts.
The value of global M&A deals set records last year, and the worldwide value of LBOs rose a stunning 156%, to $693.5 billion, surpassing the record levels of the late 1980s. The barbarians are no longer at the gate; they’ve stormed the castle.
High-yield bond issuance has risen markedly, but financial sponsors’ accelerating preference for loans to fund buyouts and recapitalizations has pushed leveraged lending to greater heights. Banks continue to lead league tables for that type of lending, and bankers, analysts, and regulators all say credit risk is only one aspect of an emerging, complex set of risks that private equity and leveraged lending carry.
“I see a triangle developing here in the commercial credit space: credit risk, liquidity risk, and reputation risk,” said Kathy Dick, the Office of the Comptroller of the Currency’s deputy comptroller for credit and market risk. “And a lot of this is arising because of the changing role our banks have taken in terms of originating but not necessarily holding a lot of credit risk.”
Reuters Loan Pricing Corp. said a record $612 billion of leveraged loans were issued last year, well ahead of the previous record of $500 billion set in 2005. The fact that the new record was set despite waning refinancing activity signals particular strength in net new issuance, which more than doubled the high-yield bond market.
Rating agencies have concluded that loans have generally been underrated in comparison with high-yield bonds; the loans offer better risk-adjusted returns, generally have floating rates that protect against mark-to-market volatility, and hold up better in the event of defaults.
“The agencies have realized that the top part of the capital structure is very well protected, even in a bankruptcy,” said Julie Persily, the co-head of leveraged finance at Citigroup Inc. “Bank lenders tend to get their money back whole.”
JPMorgan Chase & Co., Bank of America Corp., and Citi hold the top three positions in the league tables. Brooke Harlowe, a spokeswoman at JPMorgan Chase, said lending executives would not discuss the topic unless they had authority to approve quotations for publication. Bank of America would not make executives available for an interview in which their comments could be attributed to them.
Other domestic banking companies with substantial leveraged loan businesses include Wachovia Corp., Wells Fargo & Co., KeyCorp, and SunTrust Banks Inc., but smaller regional players are in on the act, too, and pick up credits even when they are not lead agents for them.
The league tables function better as a rough measure of fee income than they do as a proxy of asset growth and credit risk.
“It’s very hard to determine how much banks retain on the balance sheet,” said Meredith Coffey, the director of analytics at Reuters Loan Pricing. “They’ve got the primary market syndication, and then the secondary loan market to sell pieces of it.”
Banks also can hedge exposure through the credit-default swap market. As a result, the connection between corporate loan origination and credit risk is as weak as it ever has been. Large syndicators generally sell the term-loan portion of the credit and retain most of the revolving portion, but because the credits are hard to track — banks’ disclosure is nowhere near granular enough for that purpose – there is little definitive proof of the risk mitigation that bankers claim.
Anecdotal evidence does support bankers’ claims that they are laying off the bulk of the credits, with exactly the expected beneficial results. When technology and telecommunications companies started going belly-up in 2000 and 2001, in the midst of continuing weakness in the manufacturing sector, banking companies took some hits, but the pain was mild. That credit cycle, while most certainly an earnings event, never even threatened to become a capital event.
“It comes back to the distributing versus holding mentality,” said Blaine Frantz, a senior vice president at Moody’s Investor Service Inc. “Banks will hold risk, but over the last decade they have become more sensitized to portfolio management, and have begun to move more in the direction of the investment banks, trying to find somewhere else for that risk to reside.”
Analysts make the usual provisos that banks do not mitigate all the credit risk. With margins crushed by an inverted yield curve and a global liquidity glut, they need on-balance-sheet volume to make up the difference, and they aren’t getting it from a moribund consumer sector.
“Banks don’t have much choice,” said Chris Whalen, the managing director of Lord, Whalen LLC’s Institutional Risk Analytics. “You can sit there and suffer and have most of your business lines flat to down, or you can expand into things like C&I lending.”
Insured banks and thrifts had $1.2 trillion of commercial and industrial lending on their balance sheets as of Sept. 30, or 13% more than they had a year earlier, according to the most recent available data from the Federal Deposit Insurance Corp. The broad C&I categorization obviously includes small-business, middle-market, and large corporate lending, but there is no denying that private-equity transactions have boosted the books substantially, with their attendant risk.
“While they don’t keep a lot of it, they keep some of it,” said Tanya Azarchs, an analyst at Standard & Poor’s Corp. “It’s not enough to bring the bank down by any means, but it’s enough to create some pain.”
The syndicated loan market is, in theory at least, an elegant distributor of risk. Those looking for the greatest rewards are bearing the greatest risk. Right now the risk-takers include pension funds, mutual funds, insurance companies, structured finance vehicles like collateralized loan obligations and collateral debt obligations, hedge funds, and, obviously, the private-equity funds acting as financial sponsors for portfolio companies floating the loans in the first place.
The sponsors are hardly hurting for funds to put to work. Money has been pouring into the sector, giving it unprecedented power and scope. Hardly a day goes by without a private-equity shop announcing the creation of a new buyout fund searching for targets.
This month Kohlberg Kravis Roberts & Co., one of the most venerable names in the field, was rumored to have closed a new $17 billion fund. Depending on the leverage it puts to work, the fund’s buying power would be in the range of $70 billion to $90 billion.
That’s a lot of jack.
“What is surprising is that the flows are continuing to be wide open,” said Jim Moss, a managing director in Fitch Inc.’s bank group. “People are looking for ways to put the money to use, and private equity is going out and doing larger deals than they have in the past.”
The ramifications are startling. Huge companies struggling to meet shareholder expectations are in private equity’s sights. Consider Home Depot Inc., which has disappointed shareholders and recently paid its chief executive, Bob Nardelli, $210 million to disappear.
“A few years ago Home Depot was too big of a deal and too big of a company to be managed by private equity, but I don’t think that’s the case anymore,” Mr. Moss said. “Among very knowledgeable people, I don’t think there is a belief that size is a determinant in whether private equity is the right way to do a deal.”
The names prove the point. Last year’s deal for HCA Inc. topped the 1989 RJR-Nabisco Inc. deal as the largest private-equity buyout in history — a reference point that seems destined to be swallowed this year.
Other recent large deals have involved Freescale Semiconductor Inc., Kinder Morgan Inc., Clear Channel Communications Inc., and now Equity Office Properties Trust, for which buyout funds are now waging an epic battle.
Though the sheer size of the deals may create some apprehension, Ms. Persily says that where LBOs are concerned, bigger is better.
Today’s buyouts are for “more stable and better-quality companies,” she said. “We think we have less risk in our loan portfolio today than we did 10 years ago, because big companies are less volatile.”
But the kind of liquidity necessary to take down companies of that size rarely comes without some tradeoffs. Deal valuations have soared to levels that are hard to fathom; loan terms are loose, and covenants are weak.
“The ultimate value of some of these transactions is debatable,” Mr. Frantz said. “But they are able to fund some very large buyouts because there are a number of banks willing to provide the financing.”
In a survey released Oct. 18, the OCC found that 62% of banks active in leveraged lending had eased standards in the past year — almost double the 2005 level. Its bank examiners found increasing credit risk in commercial portfolios, and leveraged lending and large corporate loans were two hot spots.
“There is a lot of money chasing these deals, so as a lender, you’re not getting all the terms and conditions you might want,” Mr. Moss said, and the weakening is typical of the late stages of a credit cycle.
The buyout companies need cheap loans and tend to use more leverage than strategic buyers to make the deals pay off for their equity investors.
“The multiples are so high and the competition for deals is so intense that the only way the private-equity funds can continue to hit their return hurdles is to use a lot of leverage,” Mr. Whalen said.
Ms. Persily said that she does see some cyclical activity, as well as perhaps a secular trend among some public companies to avoid burdensome regulation, but that it should not have much impact on credit.
“There is more cash coming in to the marketplace through CLOs, CDOs, and hedge funds, and that may have an influence on the pricing of these loans — the Libor margin,” she said. “I don’t think it has an influence on the quality of the loan and the likelihood of payback in a bankruptcy.”
But history has shown that some deals inevitably go bad, and the changing profile of investors left holding the paper likely will lead to some interesting workout meetings. Banks that funded debt at par may end up negotiating with hedge funds that bought it at 20 cents on the dollar.
“It is no longer going to be a club of banks in a room working together,” Ms. Azarchs said. “Some hedge funds … may enjoy the idea of a bankruptcy, because they wind up holding the equity, which may be their endgame anyway.”
That’s the price of mitigating risk by selling loans to nontraditional players.
Banks that syndicate loans face risks other than the traditional credit ones. Underwriting a loan and acting as an agent for its syndication puts lead banks in a delicate position if the borrower defaults. Regulators claim that operational risk in syndicated lending is as important to them as the credit risk. Given the litigation charges that large banking companies have taken in recent years, those concerns are well founded.
“The legal reputation risks, we believe, are here to stay for a long, long time,” Mr. Frantz said. “Banks are not there to underwrite losses for investors, but that doesn’t prevent you from being sued and having to settle to make things go away.”
An eventual decline in private-equity activity certainly would hurt many large banking companies’ fee businesses, but the bigger risk may be what market conditions are when some of the lending facilities start maturing.
“These borrowers at some point will be looking to restructure or refinance, and today there is a lot of market liquidity and a lot of investors that will happily buy these facilities, whether they are buying loans, collateralized debt obligations, or some sort of structured products with the loans underlying,” Ms. Dick said. “It’s certainly possible that a change in the environment with respect to market liquidity could lead to a change in the credit risk profile in the banking system.”