Despite Staggering Price Tags on Bids, Potential for Profit Attracts Financing
The recent surge of multibillion-dollar leveraged buyouts--capped by Kohlberg Kravis Roberts’ $20.3-billion bid for RJR Nabisco announced Monday--raises some basic questions: Is there enough money to finance these giant deals? And where does that money come from?
For stockholders or investors hoping to profit from such takeovers, the answers are encouraging, takeover experts said. Banks, insurance companies, pension funds, brokerage firms and individual investors are flush with funds and are eager to provide LBO financing, thanks to the potential profits.
An LBO is an acquisition relying on high debt eventually paid off with the target company’s revenues or assets. With those involving a strong target company such as RJR Nabisco and a well-regarded sponsor such as Kohlberg Kravis Roberts, raising $20 billion is not seen as a major problem.
3 Levels of Financing
“Raising $20 billion is never easy, but because of KKR’s track record and the attractiveness of RJR the deal should be obtainable,” said Douglas K. Le Bon, who assesses LBO investments for pension fund clients in his capacity as a vice president at Wilshire Associates, a Santa Monica investment advisory firm.
“If the numbers work, there will be enough money,” said Carl White, head of investment banking in the Los Angeles office of Kidder, Peabody & Co.
Problems in financing tend to come when target companies have troubled operations, takeover experts said, noting worries that a recession or sharp rise in interest rates could spell disaster for many LBO companies unable to meet debt payments.
Funding an LBO typically involves three levels of financing--bank loans, so-called junk bonds and equity.
The first, and least risky for the provider of funds, involves bank loans (also called senior debt because lenders providing loans are first in line to collect in a cash crunch or bankruptcy, and the loans often are secured by company assets). Typically, in larger deals, bank loans represent between 50% and 70% of total financing.
One or two banks usually agree to act as a lead bank or banks, committing to provide the entire loan amount. They then turn around and sell major pieces of that loan--usually three-fourths or more--to other banks. In exchange, the lead banks collect lucrative fees in some cases exceeding 2% of the total loan amount. And the loans typically earn a higher interest rate than other types of corporate loans, averaging about one or two percentage points above the prime lending rate but in some cases going as high as four or five percentage points above the prime.
Accordingly, LBO financing has become one of the fastest-growing and most profitable forms of lending for commercial banks. Since June, it has accounted for 30% to 40% of total commercial lending, or about $33 billion in outstanding loans in the June-August period, said Christopher L. Snyder Jr., president of Loan Pricing Corp., a New York firm that tracks commercial loans.
“It’s a big explosion,” Snyder said, adding that with demand for LBO loans growing sharply this year, the “spreads” on the loans above the prime rate have widened, making the loans more profitable. “At the spreads they are getting, the credit will be available” for deals like RJR Nabisco, he said.
Banks most often taking lead roles include New York’s Citibank, Bankers Trust and Manufacturers Hanover, with regional banks such as Wells Fargo in California taking large pieces of loans. Wells Fargo and BankAmerica had $3 billion and $2.2 billion of LBO loans outstanding, respectively, greater than any of the New York banks, according to a December, 1987, report by banking analyst George Salem of Prudential-Bache Securities.
The second level of financing, also called the “mezzanine” level, involves high-yield “junk bonds” or other forms of so-called subordinated debt. This debt typically accounts for 20% to 25% of larger LBOs, with the percentage rising in smaller buyouts.
Huge Junk Bond Market
In this level, an investment banking firm typically sells bonds to pension funds, insurance companies and other institutions as well as to the public through junk bond mutual funds. Investors at this level also often take ownership positions in the companies being taken over.
The biggest player in arranging junk bond financing for LBOs is Drexel Burnham Lambert, but other big Wall Street firms also have become major participants. Big investors at this level include such firms as General Electric Financial Services, Equitable Life Assurance Society of the United States and Prudential Insurance Co., takeover experts say. The junk bond market has grown to as much as $140 billion, some takeover experts estimate.
The third aspect, which is most risky to investors, is the equity level. Here, investors put up money and take stock in the firm being acquired in hopes that the value will go up over time and earn them returns that have averaged as high as 25% to 40% on an annual basis. But if the company fails, they can end up with nothing and, unlike bondholders, generally get no interest payments.
Leading LBO sponsors, such as Kohlberg Kravis Roberts and Forstmann Little & Co., as well as investment banking firms such as Merrill Lynch and Morgan Stanley, have raised billions of dollars for taking equity stakes in LBOs. Those funds have come primarily from pension funds, insurance companies, investment banking firms, wealthy individuals, and managements of the target companies.
Some industry experts estimate that between $25 billion and $50 billion is available to take equity positions in LBOs. That is enough to launch takeovers worth between $250 billion and $500 billion, since the equity portion of an LBO typically amounts to about 10% of the total financing, with bank loans and bonds taking up the rest.
