Equity bridges explained
Bridges are supposed to get you from one place to another without getting your feet wet. Overload them though, and they can collapse. That goes for equity bridges as well as the real-world kind. Six big recent and pending deals have mustered $15bn of these financing structures between them: Alliance Boots, First Data, TXU, Clearchannel, EOP and a mooted bid for Altadis. But the risks for the banks are disproportionately high. Sooner or later, one of them will get a soaking.
A relatively new invention, equity bridges are something like bridge loans – but as the name suggests, they’re used to finance the equity part of a buyout rather than the debt. A group of banks writes a cheque for part of the deal, each typically taking $100m-$500m. The buyout shop then markets the equity to favoured partners, such as pension funds. If they buy it, the bank is off the hook, and gets a small fee, maybe 1% or less.
The problem comes if the private equity house can’t sell the equity, and the bank gets stuck with it. The fee is higher if that happens – around 5% in some cases. But if the private equity group’s nearest and dearest don’t want the equity, the bank probably doesn’t either. It then has two choices: sell the equity at a big discount, or write down its value and keep it. A bridge loan might have to be written down by 20%. Equity, possibly much more.
Using these bridges, recent buyers have been able to pull off deals in the manner of a snake swallowing an egg. That suits them fine, of course. So long as the banks are happy to stump up interim funding, private equity groups don’t need to form unwieldy consortiums. The paper in question is often voteless too, so they needn’t share control. Better yet, they can still demand management fees and a cut of profits – albeit more like “1 and 10” than “2 and 20”.
In this year’s Alliance Boots buyout in the UK, KKR got joint control of a $24bn company for just $2.5bn in equity. At First Data, the payment-processing group, KKR stands to get control of a $29bn company for $2.8bn. Once, buyout firms would put up 30% of a deal’s value in equity. Bridges can make that more like 10%.
Who’s in, who’s out
These bridges are a clear sign that the balance of power has tilted from banks to their buyout clients. Consider the bank’s position. It takes the risk for the equity onto its books. Yet it has no control over how the equity is sold, unless things go wrong. The buyout firm is essentially setting up shop on the bank’s balance sheet. And the maximum upside for the bank if all goes well is a measly 1% fee.
Why would banks take on such a risk for such a low reward? The answer is simply that private equity clients are so lucrative they have little choice. Buyout shops will raise $500bn of funds this year, reckons Private Equity Intelligence. That enables buyout barons to demand increasingly aggressive commitments from their banks. The banks fear that if they won’t underwrite the equity, they won’t get to provide debt either. In rare cases, banks have been thrown off advisory mandates for refusing to take part in a bridge.
One might expect the biggest banks to be above this kind of arm-twisting. Not so. Goldman Sachs, Merrill Lynch and Citigroup are all understood to be reluctant to underwrite equity bridges if they can help it. But all three have found themselves doing so. Merrill sat out Boots and Intelsat, but not First Data. Goldman wriggled out of bridging TXU and the mooted bid for Altadis, but supplied the equity bridge for EOP. Even those who privately admit they don’t like bridges won’t rule them out.
Ironically, one of the factors tilting the balance of power is the banks’ own hankering for private equity assets. Some of them, like Goldman and Morgan Stanley, have dedicated private equity businesses through which they co-invest. JP Morgan, Citigroup and Deutsche Bank, meanwhile, have “side-pockets” of cash, often raised from employees, to deploy on deals they like. For them in particular, providing a bridge can be a good way of negotiating for a piece of the equity in an attractive deal.
It should be stressed, though, that co-investing in a deal you really like is very different from having to invest in a deal nobody else wants.
So far, there haven’t been any problems. Many bankers think it’s only a matter of time, though, before a bridge collapses. If that happens, the consequences could be pretty serious. First, a collapsing equity bridge might well coincide with creaks elsewhere on the deal – say in a bridge loan. The same banks are usually involved on both the equity and debt in any given deal. In that context, recent wobbles in the LBO debt market are a touch worrying.
Second, the fact that each bridge consists of a number of banks means even a small blow-up would touch on a lot of institutions. An individual exposure of even $500m may not sound like much. But by making everyone involved more nervous, a stuck bridge might perceptibly increase risk aversion at the centre of the financial system. That would be likely to have a knock-on effect in other financial markets.