News from the Tennessee Valley Business
SUNDAY, MAY 27, 2007

Debt-laden buyouts pose risk for lenders, borrowers

By Rachel Beck
AP Business Writer

NEW YORK — Bank of America CEO Ken Lewis knows what it will take to wake up investors to the risks of highly leveraged buyouts. “We need a deal to go bad, as long as we’re not in it,” he said earlier this month.

Should that happen, many on Wall Street will be caught in the downdraft since they’ve largely chosen to ignore warnings that piling on big debt to corporate balance sheets puts both lenders and borrowers in danger.

Underwriters of such loans aren’t fly-by-night companies, but some of the biggest banks and Wall Street firms. Should they find themselves exposed to a lending mess, count on the fallout to be widespread.

It’s no secret that leverage is a major component to dealmaking today.

Private-equity firms couldn’t be scooping up public companies at such a rapid pace if they didn’t have easy access to cheap financing, which has become more readily available thanks to low interest rates and a global liquidity boom.

Buyout firms often add debt to the balance sheets of the companies they are acquiring and the result has been credit rating downgrades of high-quality corporate securities to junk levels.

So far this year, there has been $294 billion in U.S. leveraged buyout lending, up 55 percent from the $189 billion seen during the same months in 2006, according to Standard & Poor’s Leveraged Commentary & Data Group.

For all of 2006, there was $480 billion in leveraged loans, more than three times the levels seen in 2002.

Charlotte-based Bank of America Corp. knows how this business goes. It is the second-largest arranger of such loans, trailing JPMorgan Chase & Co. and ahead of Citigroup Inc. It’s a lucrative business: Lenders on average get between 1.5 percent to 2.5 percent in fees on the value of each loan package they fund, which so far has delivered a nice jolt to bank profits.

Competition for such lending is intense, which has led arrangers to ease the protections on their loans. More than a third of all lending during the first quarter of this year came with less restrictive “covenant lite” terms, up dramatically from the 7 percent seen in the same period of 2006, S&P said.

Enthusiastic stock owners

Stock owners are enthusiastic about this dealmaking since they get bought out at hefty premiums. The only investors who have been hurt by all this so far are existing corporate bondholders whose holdings go down in value as the companies add debt.

But generally the collective amnesia about risk continues so long as buyout firms can service the debt.

Right now, default levels for leveraged debt is at a record low of 0.44 percent, down from 1.53 percent a year ago, according to S&P. Default rates peaked at 8.2 percent in 2000.

Still, looking at things that way may be shortsighted. Should companies carrying the massive debt see a sudden turn in business for whatever reason — sinking demand for their products, higher input costs, an outside shock with global effect — the prospects of default sharply rise.

Most lenders try to decrease their exposure to such defaults by “syndicating,” or selling portions of their loans to other banks or institutional investors, but that doesn’t protect them while they hold a loan.

Also, many banks offer “bridge loans,” which provide short-term financing before long-term debt financing is secured.

Those loans also face the risk of default should the borrower not be able to lock in permanent financing.

The fact that industry leaders like Bank of America’s Lewis are beginning to talk openly about the growing risks should be a wake-up call to everyone.

Speaking earlier this month at the Swiss-American Chamber of Commerce in Zurich, Lewis called for “more sanity” in leveraged lending.

“We are close to a time when we will look back and say we did some stupid things,” he said.

Fed Chairman Ben Bernanke discussed the “significant risks associated with the financing of private equity, including bridge loans” during a conference in mid-May in Chicago.

He called on banks to closely evaluate their lending risks not just in “the context of a highly liquid, benign financial environment, but in one that might seem to be less liquid and less benign.”

Star British fund manager Anthony Bolton also weighed in, highlighting the potentially market destabilizing effect should things turn ugly. “It is only a question of when rather than if (things go wrong),” the Financial Times quoted him as saying during a speech upon his departure from Fidelity this month.

Should things go that way, lenders could suddenly end up owning companies they had no intention of buying or finding their own balance sheets stretched as they write down the value of such debts. That will surely lead to tighter commercial lending terms, which could quickly slow the pace of buyouts and give stock investors heartburn.

It’s also worth noting that a good bit of Americans’ retirement funds are also tied up in the LBO craze, either through direct investments in buyout firms or loan purchases. Given that, the debt-laden dealmaking could suddenly become a lot harder to ignore.

Rachel Beck is the national business columnist for The Associated Press.

Copyright 2005 Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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