US banks embrace LBO risk, shrug off worries
NEW YORK, March 27 (IFR) - US banks are planning to take more leveraged buyout risk onto their books, unfazed by alarm bells sounded by the Federal Reserve and rating agencies that an upswing in LBO business could lead to a return to pre-crisis recklessness.
The big banks insist that they are already highly disciplined and follow risk management processes - including monitoring how much they have in committed junk-rated financings at any one time - similar to the Fed's latest guidelines on managing exposure.
If anything, the banks say, they have the capacity to take on more risk.
"The big banks have gotten very healthy," said Gerry Murray, head of North American leveraged finance at JP Morgan.
"They have excess capital to put to work, and so I think they will get more aggressive around (LBO) deals, particularly if they feel good about the company and where the economy is heading," Murray told IFR.
The new Federal Reserve guidelines come as the Fed's own quantitative easing measures have created one of the biggest booms in the history of leveraged financing, with companies eagerly taking advantage of investor quest for yield.
Access to easy money and an improvement in the economy has spurred the return of US$10bn-plus LBO deals, such as Heinz's US$28bn buyout by Berkshire Hathaway and 3G Capital, and the proposed US$24.4bn buyout of Dell by its founder Michael Dell.
That in turn has sparked concerns that the LBO market could be heading back to the dizzying pre-crisis heights of 2006 and 2007, which peaked with TXU's US$45bn buyout - and which ended up with banks stuck with more than US$150bn of LBO financing that they couldn't sell.
While recognizing today's banks are prudent in their lending practices, Fitch Ratings bank analyst Christopher Wolfe said this was also the case before the pre-crisis market heated up.
"The issue is that, pre-crisis, risk controls were eased at some of the banks in order for the LBO business to occur," Wolfe said.
"There is always that tension in the market, in terms of how a bank balances the needs of the clients at the same time as making sure they are not taking on undue risks."
HIGH-GRADE OR HIGH YIELD?
Yields on leveraged loans and high-yield bonds have plunged this year to levels that now look more like investment-grade pricing, and offer little in the way of a cushion against rising rates.
For its buyout, junk-rated Heinz last week sold US$3.1bn of 7.5-year second-lien, senior secured notes in the bond market at a coupon of just 4.25% - the lowest on record for a comparably-rated bond.
Bankers say the problem is not too much LBO business, but not enough to go around.
"The business is very healthy and far more disciplined compared to where it was six years ago, but we are in a situation where there is a desire by some players to increase their risk appetite to gain market share," said Tom Cole, co-head of US leverage finance at Citigroup.
"We will have to choose how we respond to that," Cole said.
"Until there is a significant market sell-off, I would expect to see a continuation of this trend of increasing risk appetite."
According to some bankers, private equity sponsors orchestrating a buyout of a company will push smaller banks desperate for business to accept aggressive financing terms, which they then shop around to the bigger banks.
NOT THERE YET
Still, today's LBO market is a long way from being anything like it was in the heyday - not in terms of size, pricing, leverage, sheer deal volume or even the way business is done.
"On a relative scale, the US LBO business today is still very small, especially for the largest US banks," said Rob Harteveldt, global co-head of fixed income and global head of leveraged finance origination and trading at Jefferies.
The bigger players are naturally constrained by new Basel III rules, which require more capital to be set aside for riskier assets, as well as the stress tests the banks are now put through by the Fed every year.
And equity sponsors, who are sitting on around US$342bn in committed but unused capital, are no longer banding together in consortiums for mega-LBOs like they did in the old days.
Citigroup's Cole said that the total volume of LBOs over US$500m in size last year was US$63bn, and that the average amount of unfunded commitments for the banking system was around US$20bn - compared to about US$150bn in 2007.
The average size of a buyout over US$500m in 2012 was US$1.33bn and there were only 11 deals over US$2bn.
"Are we going to see a lot more jumbo LBOs like Dell and Heinz? I don't think so," Cole said.
"Those deals are anomalies, rather than new market trends. I believe we will see more large deals over US$5bn this year, but it is very difficult for private equity players to pursue deals larger than US$15bn without a partner with deep pockets, as they no longer want to participate in large consortiums."
In addition, the average length of time that banks commit to an LBO financing has shortened significantly from what was once as long as 12 months. Long financing commitment times was one of the reasons why the level of hung deals was so high in 2007.
Now financing commitments extend from roughly 90 days to four months. And caps on committed financings are also significantly higher.
"We used to cap a deal that was committed to financing at 9.00% at around 10-10.5%, or about 50-75bp more than where the deal was expected to price," said one head of leveraged finance.
"Now market cap is 175bp in the loan market and 250-300bp wider than the execution level in the bond market."
The percentage of LBOs with more than 7-times leverage was zero last year and year-to-date, compared with a peak of 17.72% in 2006 to first half 2007.
Still, bankers privately concede that the markets have often got it wrong when it comes to figuring out that things have gone too far.
"The funny thing about lines," said the leverage finance head, "is that you never know you've stepped over them until after the fact."