Should Banks be Worried About Equity Bridges?

Michael Flaherty of Reuters is very concerned about equity bridges. Just think of the downside to the banks concerned of these high-risk, low-return vehicles!

In an equity bridge, investment banks lend some part of the purchase price of a company which is being taken private. They then sell the equity to investors after the deal has closed. Reports Flaherty:

The best-case scenario is that the investment banks quickly sell the equity exposure to other buyers. But even then, banks typically earn only a 1.5 percent return on the loan. That means for risking $500 million, they earn just $7.5 million.
The worst case is that banks can't sell down the equity. Then they are left holding the bag, in some cases with hundreds of millions of dollars in exposure.

The 1.5% return is interesting to me. Obviously these bridges are designed to last only a few weeks, and equally obviously their exact duration can't be known in advance. But let's say they last for one month. Then the $7.5 million earned on a $500 million return would correspond to an interest rate not of 1.5% but of something closer to 18%. Which is really not so shabby.

And then of course there's the opportunity cost of not extending the equity bridge. Refuse to offer such a thing, and you won't get the associated M&A mandate – which will undoubtedly be extremely lucrative.

Finally there's the question of the downside risk. I'm pretty sure that Flaherty is wrong when he says that the risk is that the "banks can't sell down the equity". Instead, I think that Andrew Ross Sorkin is right, when he says that

If the private equity firms cannot find new investors — and it is their job, not the banks’, to find them — or if the value of the asset falls sharply, the banks are left holding the bag.

In other words, there's no actual work involved here, for the banks, beyond writing a big check and receiving in return a bigger one a few weeks later. And indeed Flaherty doesn't find a single person who thinks that there's a serious risk the equity won't get sold. Instead, he warns more darkly about the bigger picture:

LBO deals are still being pumped out with no end in sight. But the growing prospect of interest rate rises has led some analysts to believe the frothy debt days are numbered.

That's as may be – but the fact is that if there's no frothy debt, then there won't be any equity bridge either. The equity is the final piece, which gets layered on top of all the debt. If there's no debt, there's no equity, and if there's no equity, there's no equity bridge, and no risk of it failing to get distributed.

In fact, the way that private-equity shops are structured means that the equity almost sells itself, as I explained in February. If you're the kind of person or institution who's happy to invest money in a private-equity fund, you'll be ecstatic at the opportunity to take out an equity bridge, since you get much more upside that way.

Equity bridges are certainly a sign of the frothiness of the market. But I don't think they're particularly risky in and of themselves – especially if the M&A bankers at the banks concerned are doing their jobs right and are convinced that the deal is a good one.