Business Insight Zone

The financial markets have been in a tizzy about what it will take for KKR to close its planned $26 billion buyout of banking transaction processor First Data. If the details in this Wall Street Journal story hold true, the answer seems to be: a covenant, but not higher interest.

What’s a covenant? In this case, a specific provision in the borrowing agreement that holds KKR responsible for making sure that First Data meets certain EBITDA benchmarks in order to keep its creditors happy.

What’s the bigger picture? Why is this important? The banks lending money to KKR were able to extract better terms from the buyout shop to cover their own risk in providing the money for the buyout. This is important because the current credit squeeze has heightened banks’ concerns about how much risk they face, and the restructuring of the First Data deal shows the current state of play between private equity outfits and the banks that supply them. While these firms need each other to do their business, they also want to extract the best terms possible that will still allow deals to go forward. (If you kill a deal altogether, the private equity shop loses its desired target, and the creditor banks miss out on a large pool of fees, interest, etc.) In this case, the banks were able to force harder terms on KKR — which would doubtless prefer to have no covenants imposed on its purchase — but not a higher rate of interest.

This Economist article from last week explains more about the enormous pressure on the deal market in recent weeks, as mortgage problems have spread and credit markets have tightened. It cites the (then-unknown) outcome of the tricky First Data deal as a sort of bellwether for the broader deal market.

First Data will set the tone for other deals, such as the takeovers of TXU, a utility, and Alltel, a mobile-phone firm. The main obstacle is that the First Data deal “has all the bells and whistles of the bubble era”, says another banker: it is [i.e. was], for instance, “covenant-lite” and offers lenders little protection.

Banks would love to wriggle out of the most egregious deals, or at least get better terms. But that is proving hard. They painted themselves into a corner when the market was booming. [...]

As if the buy-out issue was not bad enough, banks face a bigger danger elsewhere, linked to the subprime-mortgage crisis. This threat involves a series of specialist investment vehicles known as conduits and structured investment vehicles (SIVs). Conduits were mainly set up by banks as “off-balance-sheet” vehicles for themselves and their customers that allowed them to invest in slightly riskier assets. SIVs tend to be independent. Both borrowed partially (but not exclusively) in a form of short-term debt known as asset-backed commercial paper.

The investors who bought this paper are now deciding it is not worth the risk. That gives the conduits and SIVs a problem. Moody’s, a rating agency, says many have found funding “either impossible or achievable only at exorbitant levels”. On September 5th the agency downgraded (or placed on review) some $14 billion-worth of bonds as a result. [...]

Banks are now finding that these risks are coming racing back onto their balance-sheets. It is an ugly prospect since Tim Bond of Barclays Capital estimates that $1.4 trillion-worth of conduits are out there. Either the banks will have to lend money directly to them, or they will end up owning a ragbag of securities — including some dreaded mortgage-linked bonds.

What seemed a clever wheeze to avoid the scrutiny of the regulators and auditors now looks foolish, since no bank knows the exposure of any other. Worse, none knows the extent to which it will end up on the hook itself. As a result, banks are hoarding their capital rather than lending it in the money markets.

You could be forgiven for reading “off-balance-sheet,” remembering the Enron debacle, and experiencing a burst of the heebie-jeebies. I don’t think anything we see here will turn out that badly. Banks should be minding their business better than that, we haven’t seen any evidence of widespread fraud, and in this case, off-balance-sheet arrangements are more kosher, since banks routinely use all kinds of them to carry out the sophisticated dealings with which they lubricate the financial markets.

But . . . whether we’re talking about a mom-and-pop store, your own checkbook, or the balance sheet of Goldman Sachs, it’s always trouble when you don’t have an accurate picture of your assets and your liabilities. If the problems are as general as implied by the last paragraph quoted above, some financial houses will find themselves caught up short — much shorter than they would like — as the credit crunch unfolds.

Category: Deals, Finance & Real Estate