My Thoughts on the Cycle (From LBO’s to sub-prime)
Wall Street is a funny place. Your friends are almost worse for you than enemies. At the top of the market every deal worked. You would enter into a commitment that might have been aggressive for the market, but the truth of the matter was that in an environment where spreads are tightening (essentially rising prices) the market was subsidizing your poor choices. For those that don’t know how the process works, I’ll go through a sample time-line and try to keep it as generic as possible.
- A deal is brought to an investment bank, by a sponsor of some kind or a corporation.
- The investment bank bids on some aspect of the deal. For an acquisition or L.B.O. it’s usually a role in the debt.
- Banks go out to the market and solicit “color” (information). This is used to figure out what economic terms they should quote for a role in the deal. For example, they might offer to arrange a set of loans at an interest rate of 400 basis points above some benchmark (LIBOR, treasuries, swap rates, etc.) based on the information they received.
- A process is run to determine who has offered the most attractive terms.
- The firms are offered roles. Some might lead portions of the deal and some might just earn fees. The nuances of the various roles and how they work varies based on the product in question (loans, bonds, equity, etc.).
- The terms that banks will be agreeing to if they take a role are given to them–these terms are derived from the terms proposed by the banks themselves (see #3). From what I have seen a role is rarely turned down. Not only that, but any given term offered on the deal might be incrementally worse than the worst proposal drawn up by the banks (an aggressive sponsor, for example, will take conditions or covenants and make them more lax, and then present that set of terms–any bank that doesn’t have access to all proposals will be none the wiser until much later).
- Banks accept roles and begin the process to close the deal, due diligence the various points that were represented to them, and documenting everything that has been agreed to already. Banks will also, later in the process, begin their process of distributing whatever risk they have taken on (once again, bonds, loans, etc.) where applicable.
Now take into account the fact that P.E. firms have been paying billions in fees, that the leaders of these P.E. firms have very senior relationships, and investment banks have league table pressures. The fact that investment banks trip over each other to bid for a place in deals, sometimes through the market (and, if you read the prescient piece by Steven Rattner you would know banks even rushed to reprice loans as the market moved in their favor, giving P.E. firms back some of the upside despite the fact that the P.E. firms took no risk). Now you see P.E. firms sticking it back to the banks again. While banks were rushing to give back money and while the secular direction of the market was bailing banks out of bad decisions everyone was making money but P.E. firms were making more than their fair share. Now that the market has stalled and banks are stuck holding lots of inventory and sitting on the losing side of underwater commitments there is nearly no movement o the part of P.E. firms.
Now you see investment banks putting some protection for themselves where they should have had them before (the same way P.E. firms have protected themsevles), but there are still these pressures. You still have banks swallowing their pills for P.E. firms–all while these P.E. firms are doing deals that only work because of the banks. This isn’t a relationship or a partnership. And the question is, how will this affect business going forward? I would imagine there would be more outs built into the legal agreements between banks and sponsors (P.E. firms are often called financial sponsors) now. One would also hope that there would be a very senior understanding that economic flexibility works two ways.
Now, one thing I see all over is how, much like a fractal the same tricks are employed by Wall Street over and over again. The situation described above is essentially EXACTLY the same way the sub-prime situation occurred. Banks bid on loans that they could profit from during a tightening spread environment because the market would bail them out. I remember when sub-prime loan packages were being bought from originators at 103% of their face value (100 million on loans would sell for 103 million dollars). And now, just like with L.B.O. debt, the day of reckoning has come. Except here, banks can’t really rely on relationship or even a central entity to bargain with to try to get themselves out of their predicament–their own short-term profit motivation has created the same long-term pain.