BackNeed some spunk on hung buyout loans
Need some spunk on hung buyout loans
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Banks don’t have a lot of attractive options for their hung buyout loans. They can dump them at fire-sale prices, but that means big losses and bad precedents for deals in the pipeline. They can hold them and hope for a recovery. But that absorbs capital and balance sheet capacity and leaves them exposed to borrowers’ fortunes. So some are exploring a third option: lending to distressed debt investors that want to buy the loans.
Citigroup is reportedly exploring this option with KKR’s credit fund, among others. Its rivals are having similar conversations. Such a deal might appear attractive, since it cauterizes the bank’s credit wounds. But it could also lead to a nasty relapse.
Say a bank wants to sell a credit fund $100 (Rs3,950) of hung LBO (leveraged buyout) loans. Distressed debt buyers want to pay 90-93 cents on the dollar; banks say the loans are worth par. Assume they agree on 96 cents, roughly the haircut baked into banks’ recent write-downs. The bank gets $96 and lends $3 for every $1 of equity the fund invests, or $72 in new loans.
The bank takes a loss, but it doesn’t have to hold as much capital against the new, smaller loan as it did against the longer-term LBO debt. And it frees up some balance sheet capacity.
Is this a good deal? The bank is now protected by the fund’s equity—that is, it doesn’t suffer any of the next 24 cents of loss. But if the value of the buyout debt falls below 72 cents on the dollar, the bank suffers again.
Of course, if it had held the loan, it would have taken the entire hit. So it looks to have bought some useful insurance. But it has also lost the opportunity to benefit from a recovery in the price of the buyout loan. It has locked in its 4% loss.
It could turn the tables and set up its own investment fund to buy some of the debt, using leverage and equity from other investors.
The fund would borrow less than the face value of the debt it owned, and at a lower rate, so the higher interest payments coming in from the LBO loan would cover the cost of its own debt. It would also give the fund’s investors a decent return on equity. And the bank could squeeze out some management fees.
Also, if the bank really thought the price of the loans would recover, it could put some of its own capital in the fund. That might have an added benefit.
Such a display of confidence could spur others to pay a higher price for new leveraged loans. That would help get the market moving again.
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