Be Cautious in Financing LBOs, U.S. Comptroller Urges Banks

The regulator who charters federal banks added his voice Thursday to the chorus of concern about corporate leveraged buyouts, urging lenders to develop special procedures before they take part in such debt-heavy transactions.

In a memo to executives of federally chartered banks, Comptroller of the Currency Robert L. Clarke said he was concerned that some banks might not be using proper policies, since such financing is “characterized by higher levels of risk than more traditional forms of commercial bank lending.” Success in such deals “requires a high level of financial expertise and sophisticated pricing and analytical skills,” as well as policies and controls, he said.

In a leveraged buyout, an acquirer purchases all the stock of a company, then repays the resulting debts through the company’s earnings, or by selling parts of the concern.

Such influential officials as Federal Reserve Board Chairman Alan Greenspan have recently urged caution in such lending, as banks and Wall Street firms have continued to finance ever-larger deals. Concern about the deals rose sharply after last month’s $25-billion buyout of RJR Nabisco.

The comptroller’s remarks seemed particularly aimed at the hundreds of smaller “country banks” that in the past three or four years have increasingly looked to LBOs as a way to fatten profits.

Some critics maintain that the smaller banks have been so eager to join the game dominated by the big money-center banks originating the LBO loans that they do not perform adequate independent analyses of the risks.

Despite recent criticism, however, the comptroller said in his statement that “in general, the financing of highly leveraged transactions is a legitimate banking activity, as long as a bank’s board of directors and management follow prudent banking principles to guard against unnecessary credit and legal risks.”

Good Record

Ellen Stockdale, a spokesman for the comptroller’s office, said that while several big companies that have been acquired in LBOs have filed for bankruptcy court protection, a study by the comptroller shows that most of the deals “have been performing as expected, or even better than expected.”

As he sent the memo to banks, the comptroller gave his bank examiners instructions on what kind of policies and procedures the examiners should expect of banks that undertake such lending. The comptroller’s six-page memo to examiners on the subject was also sent to chief executives of the 4,800 federally chartered banks.

Stockdale noted that the guidelines are “general,” and that the agency has no current plans to try to limit LBO lending by any bank. “At the moment, we’re just saying we expect the banks to set prudent limits on their own involvement, and follow them,” she said.

So far, the comptroller has not defined what it considers a heavily leveraged deal, she noted.

While much of the criticism of LBOs has focused on the high-yield, high-risk “junk bonds” that typically help underwrite them, about 55% of LBO lending comes from banks. The banks usually confine their participation to so-called “senior debt,” which is less risky than the junk bond portion, or the intermediate-term borrowings called “mezzanine” financing.

One bank analyst, Raphael Soifer of the New York investment firm of Brown Bros., Harriman & Co., predicted that the comptroller’s statement would cause some regional banks to take more care in making such loans. But he said he did not think the warning would worry most lenders since “the record of these loans is still so good.”

Some bankers contend that their LBO portfolios have recently had a better performance record than their portfolios of loans to blue chip corporate customers.

The volume of the loans that originating banks are passing along to others was evident earlier this week when Bankers Trust disclosed that it has originated $60 billion in such loans but has kept only $2.7 billion on its own books. Bankers Trust is the largest buyout lender.

Hard to Turn Down

Louis Lowenstein, a law professor at Columbia University and a specialist in LBOs, said leveraged buyout lending has offered banks both huge fees and loan income, at a time when profits from loans to highly credit-worthy corporate borrowers have been squeezed.

“Banks can lend at rates that are 2 to 3 (percentage points) over what it costs to borrow,” he said. “That kind of money is hard to resist.”

In the memo to examiners, the comptroller called for banks’ directors to approve statements defining their policies on such lending, setting limits on such exposure and identifying industries that are suitable for such loans. Banks should conduct independent reviews of the credit-worthiness of the LBO borrower, the memo said, and take steps to ensure that the bank does not find itself in a conflict of interest in such deals by becoming both a stockholder and lender.