Recession Would Squeeze More Debt-Laden Companies : Bank Bonanza in Leveraged Buyouts Triggers Fears

When the senior managers of Fort Howard Corp. decided to take the paper-products company private in a highly leveraged deal last month, they turned to Bankers Trust New York Corp. to arrange most of the financing.

Under a tentative agreement, Bankers Trust will lend $500 million of its own money at a lucrative interest rate and pick up a handsome fee persuading other banks to lend $2 billion more toward the $3.57-billion total.

The current boom in leveraged buyouts is providing banks such as Bankers Trust with a welcome source of income, but some analysts fear the bonanza may backfire if the economy recedes. They worry that the banks’ growing portfolios of leveraged buyouts could sour if a recession squeezes too many debt-laden companies.

In all, the nation’s 21 biggest banks have lent about $17 billion for leveraged buyouts--close to a quarter of what they have dispensed in combined Third-World loans, according to analyst George Salem of Prudential-Bache Securities.

Recession Feared

“If a recession occurs, the quality of assets of banks (with high leveraged-buyout exposure) will deteriorate further,” said economist Hugh Johnson with First Albany Corp.

Leveraged buyouts are vaguely defined as takeover deals that substitute debt for a company’s equity--sometimes at a ratio of 10 to 1. They are often used to take companies private, as in the case of Burlington Industries, a textile firm based in Greensboro, N.C., that was bought out by management and investment house Morgan Stanley in 1987. The lead financier was once again Bankers Trust.

Some leveraged buyouts are extraordinarily profitable. The biggest ever, the $6.2-billion buyout of the diverse Beatrice Cos., earned Kohlberg Kravis & Roberts & Co. more than $3 billion after the buyout specialist sold most of the pieces of the conglomerate.

Leveraged-buyout loans are attractive to commercial banks because of the high interest rates that reflect some of the risk incurred by the company in taking on so much debt. The average leveraged-buyout loan pays interest of about 10%--1 percentage point above the current prime rate and 4 percentage points above the discount rate, which represents the cost of money to the banks.

“It is also an important source of fee income,” said Eric Richards, who heads BankAmerica Corp.’s leveraged-buyout shop in New York. Fee income, which banks earn from their non-traditional operations, is increasingly important to their bottom line.

But some bank analysts worry the banks are chasing leveraged-buyout deals for the high returns without weighing the risks.

Robert Gay, senior economist at Morgan Stanley’s economics department, said: “We’ve gone through repeated cycles of overlending to various groups. We overlent to Latin America in the 1980s, we overlent to real estate in Texas, we overlent to farmers. This is a risk the banking system isn’t thinking about.”

‘Not Grasping for Earnings’

Commercial bankers bristle about the buyouts, also known as LBOs. “We’re not grasping for earnings through LBOs,” said BankAmerica’s Richards. “We have among the best analytical capabilities, and we’re better informed about the companies than most of the agents we’re dealing with.”

Thomas Parisi, a spokesman for Bankers Trust, said: “People talk about LBOs as though they were an industry or regional concentration like energy, real estate and agriculture. A well-managed LBO portfolio is highly diversified among a number of industries.

“Financings born as LBOs become less leveraged rather quickly--that results from the sale of assets and repayment from the cash flow.”

Burlington Industries, for instance, sold $400 million worth of assets by the end of last year and expects to have repaid $900 million of its $1.25 billion debt by June 1989.

The banks, too, resell 75% to 95% of their leveraged-buyout loans to foreign and regional banks, diluting their risk.

Under the worst possible scenario, if a company begins to totter under the debt load, it would stretch out its bank payments, and the banks would probably recoup the interest and principal, Richards said.

‘Not Too Soon’ for Caution

Prudential-Bache analyst Salem said he does not expect the banks to sustain significant losses this year because of their leveraged-buyout loans. But “it is not too soon to raise the caution flag to bank stock investors because too many banks have significant exposure in the LBO area, and LBO loans are vulnerable to a potential economic downturn,” he said.

“We haven’t hit a bump in the road yet,” said James McDermott, a banking analyst with Keefe, Bruyette & Woods. “The real acid test of activity is a recession.”

As the U.S. economy enters the last half of its sixth year of expansion and the “acid test” grows inevitably closer, analysts expect the surge of leveraged buyouts to taper off.

Morgan Stanley’s Gay said: “It’ll slow down because you’re getting near the end of a business cycle. It’s risky to take on debt when you won’t have the time (to sell assets or turn the company around) to pay it off.”