Equity bridges: Not as risky as they seem at first blush

There seems to be a lot of bellyaching from various pundits about equity bridges — one of the more startling innovations in the world of private-equity capital structures. Here’s Andrew Ross Sorkin explaining it, and putting the knife in at the end:

The arrangement allows leveraged buyout firms to buy companies with even less cash upfront. The idea is that the leveraged buyout firms will find other investors to ante up cash after the deal is announced.

These bridges can lead to trouble, however. If the private equity firms cannot find new investors — and it is their job, not the banks’, to find them — or if the value of the asset falls sharply, the banks are left holding the bag.

“This is how things blow up; people take more risk,” said Andy Kessler, a former research analyst and hedge fund manager who has written books about Wall Street. “If you go back to the crash of 1987, all the banks had huge bridges that went bust.”

Blogging Stocks, Dealscape, and many others are taking much the same line: look at this risky risk! Which isn’t even being priced properly! Here’s Breaking Views:

Only a few deals have had equity bridges. So investment banks haven’t really learned how to price them. Some banks have charged close to nothing – what bankers facetiously call “fee break-even.” Some have syndicated equity for free just to get the other deal fees.

But Sorkin eventually comes clean on why equity bridges in fact aren’t nearly as risky as they look at first sight:

In the case of TXU, Kohlberg Kravis and Texas Pacific are expected to invite their limited partners — the investors in their own funds, like big pension plans — to invest directly in this deal. By investing alongside the private equity firms, these investors can share in the rewards if the deal pays off without paying the same enormous fees to the firms that they typically do to invest in their funds. Private equity firms offer direct investment as an inducement to also invest in their funds that do carry fees.

The point here is that the limited partners in private equity funds, pretty much by definition, expect to get impressive returns net of those funds’ fees. And now those limited partners are being offered the opportunity to get gross returns on top of that. Given that private equity funds are having zero problems raising capital at the moment, I can’t for a minute see how any of them are going to have any difficulty syndicating the equity. It’s much more likely that their problem will be with aggrieved limited partners who aren’t able to get in on the deal.

If the bridge were to public equity, then it would be far riskier, since it would involve trying to syndicate something which was already traded on the markets. But that’s not an issue. So the only real risk here is that between the deal closing and syndication, some kind of huge event will hit the sector concerned, and that the limited partners will balk at coming into the deal at its initial valuation. But my guess is that the amount of time between the deal closing and syndication will be measured in days. The investors aren’t really buying into the specific equity risk, so much as they’re buying into the private-equity shop’s reputation for generating high returns.