NEW YORK, April 5 (RLPC) - Banks appear to have thrown wide open the door for private equity deal making. They are charging gentler fees for leveraged loans, one of the prime ingredients in crafting the buyout brew.
But digging a bit deeper suggests that a still lingering reluctance of bankers to risk their firms' balance sheets is hampering an active resurgence of leveraged buyouts (LBO).
True, the cost of capital is but one component. But it is an important one, and private equity shops, boasting $371.8 billion of dry powder in their buyout funds alone, according to Preqin, should be hungry to deploy this capital by buying, tweaking and then selling companies for a profit.
Quickly too. Triago estimates that more than half of today's buyout dry powder needs to be utilized within 21 months lest it be forfeited.
With debt prices consistent with prior periods of spirited LBO activity (though no one forecasting a return to the pre-financial crisis boom), market volatility calmed and equity valuations increased enough to make sellers willing, if not eager, that there ought to be more buyout barons pulling the trigger on deals, said market watchers. But the reality has not matched expectations.
That's because, to date, there is still a dearth of fully underwritten financings, where a bank or a coterie of banks step up to commit their balance sheet to get deals done. In other words, if the financing fails to draw enough investors to clear the market, the bank is on the hook to provide the debt.
"Many of the new issue deals we have seen in the first quarter are being done on a best-efforts basis," said Trey Parker, co-head of research at Highland Capital Management.
The bevy of refinancing, dividend payout, and amend and extend deals that have littered the leveraged loan landscape this year have been pulled off with no underwriting risk to loan providers. This year's big splash, Lawson Software's new $3.1 billion term loan, was done on a best-effort basis.
Even when banks are willing to provide fully underwritten financings, they extract a heavy price. Lenders want to be paid for their risk with expansive flex language that will allow charging far higher interest rates or steep cuts to the original issue discount to make the loan more attractive should they have misread investor appetite or if the market turns against them, they way it did last August.
Flex language in current loan commitments can turn a 6 percent cost of capital into an 11 percent one, explain market participants.
Thus, even though Six Flags Entertainment reset the loan market in December, clearing with pricing at LIB+325, 1 percent Libor floor and a discount of 99 cents to the dollar, buyout shops have to consider debt costs that are more akin to those immediate post the August volatility.
"LBO sponsors have to factor in those pricings in their worst case scenarios. It raises the cost of financing," said a loan investor.
Though memory tends to be short on Wall Street, bankers are remembering the pain of last summer when their fees, and thus their bonuses, were slashed due to inadequate flexibility to boost pricing or lower the discount. Flex amounts are declining at a slower pace than the more apparent loan pricing.
Whereas leveraged loan yields have come down from their October highs of near 9 percent to slightly above 6 percent, flex language has only been whittled down 50-100bp since that time, said sources. That means should the capital market window become unfavorable, combined pricing could shoot up to 800-1,000bp.
The dampening effects of wide flex language should not be over-exaggerated, however.
"It doesn't stop deals from happening," said Leland Hart, head of leveraged loans at Blackrock.
But it does slow deals down, especially when the future seems uncertain. Some financial sponsors complain that even with flex language, it's hard to get one bank to completely underwrite a deal.
"Banks are loath to use their balance sheets," explained a managing director at a major private equity firm. "(A banker) doesn't want to risk his job and family for it," said another private equity player.
And balance sheet considerations go beyond fears of holding unwanted loans. Bankers are also weighing how regulators assess a best-efforts deal versus a fully underwritten one.
The government applies a zero capital charge for a best-effort, such as a refinancing, since the bank is merely playing an agent role. But once a bank signs to a full commitment, it morphs into a principle taking a far higher capital charge in the process.
But banks will open their wallets again, sources said, pointing to a countervailing force. Best efforts command smaller fees, an average of 1 percent versus 2 percent for an LBO underwriting.
As the market continues to heal, the willingness to underwrite and to soften flex language will improve as well. Already, Richard Farley, lawyer at Paul Hastings, disclosed that he's seeing several LBOs in the pipeline that have $2 billion term loan debt.
Leland Hart predicted that LBO activity should steadily increase throughout the year. "There are willing buyers and the capital markets are amenable."