DealTalk: Sizing up LBO risks no easy task

ZURICH (Reuters) - European banks funding the unprecedented leveraged buyout boom may be in for a bigger profits hit than envisaged when the tide turns, but investors are having a hard time nailing down the risk.

Rising long-term interest rates may already be slowing down activity, some of it funded by "covenant-lite" and "covenant-zero" loans, syndicated loans that narrow or waive protections for lenders.

But exactly which banks are most exposed to sudden loan write-offs or a drop in fee income if the deal boom implodes is proving a difficult call to make for investors.

"A lot of information is anecdotal because there is very little hard data on the extent of exposures, the amount of fees being raised and the extent of the syndication," said Simon Adamson, an analyst at credit research firm CreditSights.

The anticipated fall in fee income that banks earn from arranging loans to fund the record pace of private equity deals is expected to be manageable for most banks even if the market goes into freefall.

"It's not going to be a decimation. It's starting to get factored into the numbers," said one senior banking analyst at a British bank, who asked not to be identified. The analyst estimated that up to 10 percent of banks' revenues were linked to the leveraged finance business.

But a bigger risk, although one which is harder to quantify, could arise for banks which have significant exposure to the leveraged loan business still sitting on their balance sheets.

"I think probably the biggest risk will be from possible credit exposure and will depend on how quickly problems happen and how much is being distributed or hedged," Adamson said. "It is a murky area."

Among the most active European banks in leveraged finance are Barclays (BARC.L), Royal Bank of Scotland (RBS.L) and Deutsche Bank (DBKGn.DE).

REGULATOR CONCERNS

Comparisons with earlier cyclical downturns are also tough because of the sheer volume of lending, the rise of covenant lite lending and the use of credit derivatives to hedge risk, which have never been seriously put to the test.

Britain's financial regulator said on Monday it was concerned about a risk of too much borrowing in private equity deals and would ask banks about their exposure to leveraged buyouts twice a year starting in 2008.

Banks say they are minimizing the risks of extending these loans by moving from a so-called "buy and hold" approach, under which loans were extended with strict covenants attached and kept on a bank's books, to an "originate and distribute" model.

That means one of the main risks now facing banks is of being unable to sell on debt of a borrower that runs into trouble in the three months or so that elapses between a lender underwriting a loan and syndicating it.

But there could be surprises in store.

"You may find banks participating in this market that you perhaps thought would not have been involved," Adamson said.

"Smaller commercial banks are more willing to keep the risk on their books whereas the main motivation of investment banks will be fees from underwriting and arranging and they tend to distribute the risk more," he added.

Others echoed his concerns that financial markets may be underestimating the amount of exposure to LBO loans some banks could be carrying on their books.

"The question is how much is staying on banks' balance sheets," said the chief equity research analyst at an investment bank in London. "It may be that not as much is being transferred off the books as the market is believing,"

"It's very difficult to gain visibility on where the damage is being done. It's very hard to see who has been clever and who is the patsy," the analyst added.

Fallout from a meltdown in leveraged finance could also hit banks' earnings from trading activities.

"Every bank is doing arrange and distribute but everyone is also carrying large amounts (of debt) on the trading book," said Simon Maughan at Blue Oak Capital in London. "They are buying back via the trading book."

"Will it derail earnings in the next couple of years? Yes it probably will," he added. "Banks and lawyers have geared up with insolvency experts, so they must know what's coming."

Pressure is building because many borrowers, who have secured loans to fund company buyouts, may have provided excessively optimistic profit projections for the firms they have acquired to secure the necessary financing.

"The real Achilles' heel," said Ed Eyerman, head of the leveraged finance team at Fitch Ratings, "is that aggressive leverage on deals has to be accompanied by revenue and profit projections that are vulnerable to an economic slowdown."