Michael Flaherty of Reuters is very
concerned about equity bridges. Just think of the downside to the banks
concerned of these high-risk, low-return vehicles!
In an equity bridge, investment banks lend some part of the purchase price
of a company which is being taken private. They then sell the equity to investors
after the deal has closed. Reports Flaherty:
The best-case scenario is that the investment banks quickly sell the equity
exposure to other buyers. But even then, banks typically earn only a 1.5 percent
return on the loan. That means for risking $500 million, they earn just $7.5
million.
The worst case is that banks can’t sell down the equity. Then they are left
holding the bag, in some cases with hundreds of millions of dollars in exposure.
The 1.5% return is interesting to me. Obviously these bridges are designed
to last only a few weeks, and equally obviously their exact duration can’t be
known in advance. But let’s say they last for one month. Then the $7.5 million
earned on a $500 million return would correspond to an interest rate not of
1.5% but of something closer to 18%. Which is really not so shabby.
And then of course there’s the opportunity cost of not extending the
equity bridge. Refuse to offer such a thing, and you won’t get the associated
M&A mandate – which will undoubtedly be extremely lucrative.
Finally there’s the question of the downside risk. I’m pretty sure that Flaherty
is wrong when he says that the risk is that the "banks can’t sell down
the equity". Instead, I think that Andrew
Ross Sorkin is right, when he says that
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.
In other words, there’s no actual work involved here, for the banks, beyond
writing a big check and receiving in return a bigger one a few weeks later.
And indeed Flaherty doesn’t find a single person who thinks that there’s a serious
risk the equity won’t get sold. Instead, he warns more darkly about the bigger
picture:
LBO deals are still being pumped out with no end in sight. But the growing
prospect of interest rate rises has led some analysts to believe the frothy
debt days are numbered.
That’s as may be – but the fact is that if there’s no frothy debt, then
there won’t be any equity bridge either. The equity is the final piece, which
gets layered on top of all the debt. If there’s no debt, there’s no equity,
and if there’s no equity, there’s no equity bridge, and no risk of it failing
to get distributed.
In fact, the way that private-equity shops are structured means that the equity
almost sells itself, as I explained
in February. If you’re the kind of person or institution who’s happy to invest
money in a private-equity fund, you’ll be ecstatic at the opportunity to take
out an equity bridge, since you get much more upside that way.
Equity bridges are certainly a sign of the frothiness of the market. But I
don’t think they’re particularly risky in and of themselves – especially
if the M&A bankers at the banks concerned are doing their jobs right and
are convinced that the deal is a good one.