May 17th 2007
From The Economist print edition
Advising on, financing and investing in buy-outs is a great business. But banks should not be too greedy
THE definition of merchant banking has changed many times over the centuries. Jews in medieval Italy, unrestrained by the Catholic ban on usury, advanced money at high interest rates to grain farmers to secure an option on their crops and then shipped the grain. One of the great investment banks of the 19th century, Barings, began life as a London outpost for the family's West Country wool business, operating as both merchant and banker. But it soon discovered that trading capital was a better way to get the attention of kings and emperors than shearing sheep.
Today Wall Street banks are once again investing large quantities of their own and their clients' capital in businesses, enjoying the same easy credit as their private-equity clients. They call it merchant banking, taking their cue from the grandfather of the industry, J. Pierpont Morgan, who created the world's first billion-dollar company in US Steel. Since the 1980s Wall Street has built up merchant banking in boom times, only to rue it bitterly afterwards. In the past three years acting as a principal has again become a big source of profit, and also of controversy, as banks try to negotiate the blurry line between advising clients, lending to them and pouring their own money into deals.
Advising companies in the S&P 500 and the FTSE 100 used to be the pinnacle of an investment banker's ambitions, and mergers and acquisitions among listed companies still account for 75-85% of global M&A volumes. But in the past three years private-equity firms have been lining the bankers' pockets. Freeman & Co, a New York consultancy, reckons that buy-out firms paid $12 billion to investment banks last year, more than three times as much as four years ago. The top private-equity fee-payer, Kohlberg Kravis Roberts (KKR), spent $783m. The top payer among the publicly listed companies, Xstrata, a global mining group, spent only $245m.
Nice little earner
A fringe benefit of advising on buy-outs is the invitation to invest in them. Here investment banks may use their own capital, as well as raising funds from outside investors in the hope of making money alongside their private-equity clients. Indeed the banks' own funds sometimes put those of their clients in the shade, though you rarely hear them trumpeting the fact. This year Goldman Sachs set itself the task of raising a mammoth $20 billion for its latest private-equity venture. It already has $145 billion of assets under management in its alternative investment funds, and $70 billion of committed equity capital in its merchant-banking arm.
Being one of the world's biggest private-equity funds, as well as one of the biggest advisers to them, could cause serious conflicts of interests. Goldman is likely to provide the third-biggest equity portion, behind TPG Capital and KKR, of the $45 billion bid for TXU, a Texas energy company. The TXU bid could become the biggest buy-out ever. At times it was hard to tell whether it was Goldman's deal or that of its clients.
Yet investment banks serve so many masters at the same time that sometimes they cannot avoid ruffling feathers. Goldman, along with other banks, has appointed senior people to prevent this happening or at least minimise the effects. “We can't avoid conflicts,” says the firm's Mr Viniar. “We have to manage them.”
In 2004 Credit Suisse (then called CSFB) and JPMorgan Chase went head-to-head with private-equity paymasters such as TPG, KKR and Blackstone and won a $1.6 billion battle for Warner Chilcott, a British pharmaceuticals company. It proved a pyrrhic victory because it upset some of the banks' biggest clients. Unusually, one of them, TPG, aired its grievances in public.
But the most gripping action in private equity is in financing. The main funding tool of the buy-out boom is what is known as leveraged lending: essentially, loans to borrowers with too much debt on their balance sheets to be judged as investment grade by rating agencies. In the heady days of the 1980s, leveraged buy-outs relied on junk bonds. But leveraged loans are now more popular than junk bonds, because they are quick to arrange and put a lender closer to the front of the repayment queue if the borrower runs into trouble.
According to Standard & Poor's LCD, a division of the rating agency, the first three months of 2007 were the busiest ever for the American leveraged-loan market. New loans totalled $183 billion, up 55% from the first quarter of 2006. The fastest growth came from private-equity groups, which raised $53 billion in three months, two-thirds more than a year earlier.
As in other parts of the debt markets, the liquidity has been fed by the large number of investors willing to buy tranches of collateralised debt obligations or, in the case of leveraged lending, collateralised loan obligations, a market which has rallied since 2002. Once bankers have underwritten the loans, they can sell them on to CLO funds rather than keeping them on their books, which may help to explain their willingness to take greater credit risks than before.
However, developments in the past year suggest that borrowers now call the shots and raise nagging concerns about underwriting standards. Buy-out firms have squeezed spreads on loans and bonds to levels that make bankers' eyes water. And despite the record investment pouring into private-equity funds, their principals have lately been passing round the hat among investment banks for “bridge equity” as well as bridge loans to do the largest deals.
For the first time, borrowers have also convinced banks to relax terms on covenants—the checks in place to make sure the issuer comes back to the table at the first sign of distress. Steve Miller, who tracks leveraged loans for S&P LCD, says that since the formation of the market in the 1980s, spreads and leverage have risen and fallen “like hemlines” and only covenants have remained constant.
But now, he says, new “covenant-lite” loans give borrowers rather greater latitude if their market sours. Such loans amounted to $48 billion in the first quarter, or one-third of the entire market, compared with just over 1% in 2005. He expects the covenant-lite market to slow, but still believes there has been a big relaxation of lending standards. As he puts it, this is “not your father's market, or your older sister's, for that matter”.
Regulators, too, have begun to express concern, seeing parallels, perhaps, with the over-optimism about the subprime mortgage market. “We are not entirely comfortable with the very high degrees of leverage in some company borrowing situations, such as private equity,” says Thomas Huertas of Britain's Financial Services Authority. “We take the old-fashioned view that the business cycle hasn't been repealed. When we see these types of deal structures it looks like the corporate equivalent of saying ‘house prices will always go up'.”
Bankers are not unaware of the risks they are running. As one senior financier in Europe confesses, “It's a bit like lending money to your children.” But the profits they can earn from the so-called triple play—advising on, financing and investing in buy-outs—make it hard to resist. Merrill Lynch, for example, reportedly earned $75m in fees for advising on the buy-out of HCA, an American hospital operator, helping to underwrite $22 billion in bank loans. It also took a $1.5 billion equity stake.
But the banks would be wise to look back on recent history. The exuberant junk-bond era of the 1980s, when high-yielding debt securities fuelled a wave of takeovers, ended with the bankruptcy in 1990 of Drexel Burnham Lambert, which had dominated the market. During the following decade, banks such as Chase Manhattan formed venture-capital arms to invest in technology start-ups. They lost heavily when the tech bubble burst.
Perceived conflicts of interest have led some investment banks to give private equity a wide berth. JPMorgan Chase, UBS, Deutsche Bank and Morgan Stanley have all retreated from merchant banking in the past half-decade, a move which some of their bankers now rue bitterly—but may eventually give thanks for.