Building bridges in the bond markets

November 5, 2009

Bond market growth has allowed companies to sidestep banks, which are reining in lending. The next stage in this disintermediation process is to extend it to areas such as funding leveraged buyouts, where banks are still in retreat. There are limits, however, to how far it can be applied.

During the boom years private equity firms were able to buy large companies by securing large bank loans that could be later refinanced with high yield bonds. But banks, many of which were left holding the loans when the crisis struck, are now unwilling to commit to large bridge loans without imposing tough conditions. That puts PE firms at a disadvantage to deep-pocketed strategic buyers.

One idea being discussed, however, is to use the bond market to help finance leveraged buyouts directly. A recent example was the structure used by private-equity owned Swiss drug maker Nycomed in its bid for Solvay’s pharmaceutical arm in September.

Under the terms of the deal, banks would have provided a bridge to Nycomed, but locked in bondholders’ agreement to buy a high-yield bond before the deal actually closed, allowing them to lay off their risk quickly. Bond holders’ funds would have been kept in an escrow account, and returned to them with a premium if the deal fell through.

Though Nycomed’s bid failed, the idea of financing buyouts by locking in investors before the deal has been completed has caught bankers’ imagination. The attraction is that it enables banks to make large financing commitments while reducing the risk that they will be stuck with the risk if markets sour.

The structure is not quite as solid as a bank loan. The buyer has to be willing to pay the costs of keeping bonds in escrow if the deal falls through, which could prove prohibitively costly for a large deal. Also, the bridge loan may have conditions attached to make the bond refinancing easier, making the financing less certain than a bid from a corporate buyer.

Nonetheless, bond markets will likely play an increasingly important role in financing and refinancing LBOs. Companies looking to sell a division, for example, could have the outline of a high-yield bond refinancing arranged for prospective buyers to use. Pushing the idea to its extremes, they could even lock in bond investors before a final buyer has even been identified — a version of the staple financing packages companies used to attract private equity buyers during the boom.

Bankers have an incentive to look for ways to finance deals and lay off risk quickly in the capital markets. Of course, many of the large private equity buyouts launched during the boom should never have been launched in the first place. But leverage may still be justified for mature companies with steady cash flows.

More stringent capital requirements by regulators have permanently raised the cost of providing large bridge loans for companies without a strong credit rating. The days of the mega bank-financed buyout are over. But the bond market is not yet ready to take up the slack.

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Very well thought out and articulated.

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