LBO Lending: What Banks Should Know

Article excerpt

America's regional banks, looking for ways to increase their margins without excessive risk, are more eager than ever these days to take part as lenders in leveraged buyouts.

With competition squeezing margins on traditional forms of lending, banks are finding LBO lending attractive. It is not only lucrative, but it also has "sizzle," making it especially appealing to regional banks ambitious to become "players."

But bankers should be aware that LBO lending is very different from "plain- vanilla" corporate lending. They should understand that the quality and track record of the buyout's sponsor - not just the strength or asset base of the business being bought out - are critical to a buyout's long term success.

In other words, they should look before they lend.

Regional banks participate in LBO lending in various ways. A few banks come into the process as advisers to a local business, whose owner wants to sell, partially cash out, or arrange a transition to new management or ownership. More get involved as participants, and sometimes co-lenders, in a larger bank's loan. Others may organize and lead a syndicate of lenders. If the deal is small, a regional bank may be the sole lender.

However they get in, what they need in the long run is to be able to get out - with the principal returned, with the interest paid, and without a black eye in their community.

Having been in the LBO business for some years, let me share some observations that may help banks to achieve those positive, long-term results. I would describe these as "the Five C's of LBO Lending."

Bankers have long been accustomed to "the Three C's of Lending" character, capacity, and collateral, the fundamental building blocks of commercial lending. Is the borrower the sort who will repay the loan, does he have the means to do so, and can he pledge sufficient assets to protect us if he doesn't pay?

The Five C's overlap a bit, but are somewhat different. They are: Constructive policies, commitment, capacity, character, and control. How well the sponsor stacks up on these measures, based in large part on the firm's prior record, may indicate how comfortable the bank will be with its loan a few years down the road.

1. Constructive policies are a tip-off. Buyout firms come in many shapes and sizes, with different styles and strategies. The firm's individual approach to the business may send out strong signals regarding a deal's probable impact on the local community - and on the bank's customers.

Are the sponsor's policies and history constructive or destructive?

Does it typically break up acquired companies, selling off their parts to recoup its investment? Or does it seek to build and enhance the businesses it buys? Plant closings hurt the bank and local business, causing bitterness and pain in the community. But revitalized businesses can grow, add jobs, contribute to the community - as well as repay debt and generate consistent profits. …