I’ve had the opportunity over the past week to spend a considerable amount of time with lenders, private equity investors and transaction lawyers in a variety of settings.  Notably, we appear to have rapidly arrived at a period of openness with respect to what we all are seeing in an effort to calibrate our own observations.  Historical experience has been characterized by a “I’m smarter than you” air.  Maybe self preservation has sobered us all up, made us willing to share.   Here are some of the key themes of my conversations.

Bank Bonanza

Opinions on the TARP program and direct bank investment plan are wildly divergent, but there is universal agreement that something had to be done to calm the markets.  Now that that has happened and a bucket of money has been set aside for the plan, a workable solution will be found.  Opinions on what will ultimately be successful show very little homogenization and do not exist at any level of granularity.  Said differently, lenders know they need to go to rehab, but no one can agree on the type of treatment, the duration and prospects for success.

People I spoke with vary in their belief as to how the injection of capital and the cleansing of  financial institutions balance sheets will ultimate manifest itself.  There are those who simply believe banks will horde the cash and take a very risk averse view towards the lending market.  Others believe the IRR in buying up senior loans in the secondary market at 70 cents/dollar is a better use of capital than making fresh forays into the corporate lending market.  Finally, there are those who believe that banks will simply use the capital to buyback their own stock.  I’m not sure I disagree with the later two assumptions.

At a panel discussion where bankers were to be talking about deal structuring, lenders who had agreed to be on the panel found themselves having an entirely different conversation — discussing the state of their loan portfolios.  Some unsuspecting folks were hit with a new question that not many people are talking about — fraud.  The question was “What percentage of your loan portfolio do you expect to find malfeasance in?”.  The question was met with silence, and then a soft “we don’t know”.  There are “Four Cs” in lending — collateral, cash flow, credit quality and character.  Much has been said about the first three, but not much about character.  It is quite conceivable that a considerable amount of fraud was spawned by the glut of cheap money and limited due diligence on behalf of lenders.

On the flip side, I’m seeing a lot of talk about de novo banks and lending institutions.  Hedge funds, individuals and new lending institutions are seeking to fill in the gaps in the lending landscape.  Who can blame them?  For smart lenders you can find fully collateralized obligations and pretty juicy interest rates.  I take this as a positive sign that there will be stop gap alternatives.

On the plus side, LIBOR has fallen for the past 4 sessions, indicating that people are moving out of treasury instruments and into equity or corporate securities.  With senior credit going for LIBOR + 650, and LIBOR previously hovering at 4.5%, you can see how the equation stopped the whole prospect in its tracks.  Pay 11% for a collateralized loan or pay 12% – 14% plus warrants for unsecured.  Relative to depressed equity prices,  that decision is still easy.

Let’s Make a Deal

On the transaction side, the world went dark for the past two weeks, but equity sources are starting to re-emerge and re-calibrate.  I’ve found equal parts who believe the earth has bent on its axis and those who think the world is just fine.   That said, I’ve seen a number of private equity parties with term sheets outstanding either pull those term sheets, renegotiate (or attempt to) on the basis that “the world has changed” or take a financing out (if they had one).  For those of you not familiar with the Hexion/Apollo Management/Huntsman Chemical situation, the concept that a down market does not make for a material adverse change (MAC) out, will have far reaching implications on the transaction landscape over the long haul.

On the private equity side, I’m also seeing a number of hung deals based on the lack of debt.  In most of these deals, we are seeing a counter of seller subordinated, and in some cases seller senior paper.  What will be interesting is whether sellers can consent to a pre-packaged bankruptcy as an impaired consenting class where they receive the lions share of the NewCo in a restructuring.  These are the things that keep me up at night.

However, where private equity buyers have pushed the pause button, strategic buyers have, thus far, stepped into the void.  Strategics are enjoying their moment in the spotlight, brought on by the absence of private equity alternatives.  That said, some of them are approaching the situation from a rather draconian perspective.  A public company buyer recently served us with a definitive agreement as a take it or leave it proposition.  I’m not sure indemnity in excess of the purchase price and 100% shareholder consent are realistic asks, yet, if ever.

Stay tuned.  I’m sure there will be chapter two in this saga.

/bryan

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