Banks look to private equity to offload debt burden

Banks that have been left with a large overhang of leveraged loans since the onset of the credit crisis last summer are increasingly turning to private equity buyers to offload some of the billions of pounds of debt that remains un-syndicated on their balance sheets. The news hit headlines in the UK recently with the news that the banking syndicate that financed the record breaking de-listing of Alliance Boots in June 2007 could sell much of the massive £9bn of debt back to KKR, the buyout house that sponsored the transaction, at well below face value. This, however, is just the tip of the iceberg. Several large global banking institutions, including Citigroup, Deutsche Bank and UBS, have already completed major transactions and in late May the first deal of this nature was completed in the UK, when Bridgepoint bought back £10m of the debt it used to leverage the buyout of clothes retailer Fat Face.

The ironic twist in the tale is that, not only are the banks selling the debt at a significant discount, but they are often willing to leverage the transactions themselves.

The motive for the private equity firms is clear, particularly as, in most cases, they are buying the debt associated with their own deals. "If the firm is comfortable with the company then this sort of transaction can be very attractive. They are buying the debt cheap and about 75% leveraged; as long as they get a solid exit in the next four years and make par on the loans, they could generate an IRR in excess of 20%", says William Allen, managing director of debt advisory at Houlihan Lokey. He does, however, warn against over-exuberance: "The default rate probability is much higher at the moment and the private equity firms are going to be much more exposed to the investments should they fail to achieve a successful exit or if the company hits trouble."

As for the banks, their motives are less clear and this has prompted much speculation in the press, most of which appears ill-founded. According to Allen, the key factor is the mounting pressure on the banks to recycle some of the capital that has been stuck on their balance sheets since the CDO markets effectively closed for business last year. Specifically, the key issue revolves around the capital rating given to the loans on their books under the Basel II regulations, which dictate how much capital banks have to keep in reserve to protect their solvency against the differing risks associated with their lending practices.

"The main issue is how the transaction is conducted. Essentially a new Special Purpose Vehicle is incorporated and the underlying loan is removed and replaced with a new loan to the SPV, which has a considerably lower capital rating. They are basically moving the debt from one part of the balance sheet to another," Allen explains. This reduced capital rating means that the bank is required to keep less capital in reserve and the deal therefore frees up some liquidity. Additional benefits are that exposure to the debt is reduced, there is a capital injection and, of course, there is interest on the loan.

In these uncertain and illiquid times, these deals provide a useful tool with which banks can gain access to capital and there is currently a clear and growing trend. However, Allen believes this will not continue in the long term: "It's a window of opportunity, and a short window at that. Not all the overhang is being sold as banks are still hoping there will be a liquidity improvement later in the year". He therefore predicts a slow down in these deals in the summer, when banks will again wait and see if the CDO market will come back to life, though there may be a pick-up again in the final quarter. "If things don't improve as they hope, and I see no reason why they will, they will face some decisions and will probably begin selling again as they won't be allowed to take a lot of this debt into 2009".

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