Acquisition bridge financing by investment banks.
As recently as the mid-1960s, the role of investment bankers in mergers and acquisitions ended when a transaction was finalized; they provided advice to clients and underwrote securities. Over the last 20 years, however, investment bankers have become more actively involved in their clients' merger and acquisition activities. Some investment bankers now initiate buyouts by describing possible targets to potential bidders; others commit their own capital by taking long-term equity positions (for example, as a partner in a leveraged buyout).
Investment bankers have also begun to provide short-term loans to merger and acquisition clients. This practice, called bridge financing, has grown significantly in the last few years and now is a standard feature in many merger and acquisition announcements.1 Critics, however, have expressed concern over potential conflicts of interest. Can an investment banker, who is both a client's advisor and a short-term creditor, objectively advise that client and underwrite securities to refinance the bridge loan? This article describes how bridge loans work, analyzes the benefits and risks both to investment bankers and to their clients, and identifies several policy questions raised by this practice. THE DEVELOPMENT OF BRIDGE FINANCING
he term "bridge loan" has traditionally
been used to describe
financing provided by venture capitalists and large institutional investors to young companies prior to their going public and to companies in financial difficulties who are trying to turn around. In the mid-1980s, investment bankers began providing "mezzanine" financing to young firms, usually in the form of debt with warrants or convertible securities. Those loans offered good potential return with possible capital gains on the equity side.
During this period, investment bankers came under considerable pressure to develop new sources of revenue. The industry was suffering a longterm decline in profits from its more traditional trading and underwriting activities as a result of deregulation and increased competition. Investment bankers identified temporary financing to support the active acquisition market of the 1980s as a potential revenue source. Some acquirers were unable to get all of the permanent financing as quickly as needed from banks or securities sales. If
investment bankers could help meet that short-term need for funds, they would then be in an excellent position to assist with arranging the permanent financing-often the sale of junk bonds or the sale of the target's assets.
Investment bankers developed two techniques to help their clients meet those short-term needs. The first, used initially by Drexel Burnham, was to issue letters of comfort indicating that the investment bank was "highly confident" that the additional financing needed for a client's offer could be raised. The second technique was to issue commitment letters for short-term, or bridge, loans to be used to complete a client's financing package.
The ability of the investment banking industry to supply large amounts of short-term funds meant that investment bankers needed to raise far more capital than they had available in the 1960s. This supply of new capital, especially in the industry's largest firms, was made possible by the consolidation occurring in the U.S. securities industry. Several investment bankers had been taken over by parent companies with large amounts of capital (for example, Prudential Bache, Dean Witter [Sears], and Kidder Peabody [GEI). Others received capital infusions from foreign investors (Goldman Sachs' sale of 12.5 percent of its stock to Sumitomo Bank) or sold stock to the public (Morgan Stanley and Shearson Lehman). Thus, in 1973, the ten largest firms had 35 percent of the total industry capital; by 1986, this had grown to about 60 percent, or $35 billion. BRIDGE LOANS IN MERGER AND ACQUISITION TRANSACTIONS
Acquisition bridge financing can be viewed as a two-step process. First, a short-term loan is used to complete a tender offer, merger, leveraged buyout, financial restructuring, or other acquisition-related transaction. Second, a subsequent securities offering, publicly underwritten or privately placed by the investment banker (or an affiliate), is used to repay the bridge loan as quickly as is practical.
The loan itself typically involves the issuance of unsecured short-term, high-interest, increasing-rate, subordinated notes to the investment banker. The notes are often subordinated to (and conditional upon) a secured bank loan used to finance the largest portion of the acquisition. The interest rate on the bridge loan is initially set 3-6 percent above a standard benchmark rate. The maturity date is established to allow sufficient time for the acquisition to be completed and the long-term financing to be arranged.
To encourage the borrower to repay the loans as promptly as possible, the interest rate generally increases with maturity. For example, the $976 million bridge loan provided by First Boston to Union Carbide as part of a 1986 recapitalization in response to GAF Corporation's hostile tender offer bore an 11.5 percent interest rate and matured in 90 days. Union Carbide could have extended the loan for 90-day periods for up to 2 years; interest rates would increase .5 percent every 90 days and at all times had to be at least 2 percent above other senior bank financing obtained as part of the recapitalization plan.
Bridge loan agreements typically contain standard loan covenants, such as requirements to maintain minimum levels of net worth and prohibitions against additional borrowings (including modifying the terms of the senior bank loan), significant asset disposals, securities repurchases, and dividend payments. In addition, bridge loan agreements usually limit the borrower's ability to make major modifications to the terms and conditions of the acquisition transaction for which the funds are being borrowed.
Borrowers are usually required to complete the second step of the process-refinancing the bridge loan with permanent financing-as promptly as practicable following the transaction. To that end, the loan agreements often include a provision that the investment banker (or an affiliate) handle the refinancing. Some of those agreements have included a "forward underwriting commitment letter" that identifies the investment banker as the underwriter and requires both parties to use their "best efforts" to complete the offering. In some cases, the details of the proposed offering (usually for unsecured, high-yield "junk" bonds) has also been included. Although the loan agreements do not always require that the bridge loan be repaid from the proceeds of such an offering, bridge loans have generally been repaid from the proceeds of a registered, underwritten public offering through the investment banker who made the original loan. In other cases, repayment has been made through subsequent bank financing or asset sales. BRIDGE LOANS-THE BORROWER'S PERSPECTIVE
ridge loans offer considerable
benefits to certain borrowers, especially
when speed, flexibility, and secrecy are vital. Bridge financing reduces the time period needed to complete an acquisition because the offer does not have to be conditioned upon the availability of permanent financing or delayed while that financing is arranged. Buyers appreciate the certainty and speed in closing transactions; sellers like to see that firm financing is in place before agreeing to sell. In fact, some have argued that the financial credibility that bridge loans provide to corporate raiders has influenced target boards' willingness to evaluate some highly leveraged acquisition proposals that they may not have otherwise considered.
Bridge loans also offer the borrower considerable flexibility and secrecy because the loan can be quickly arranged and amended. The use of bridge loans in place of private placements of securities before the planned acquisition transaction may reduce the dissemination and possible misuse of nonpublic information prior to the acquisition.
These benefits, of course, come at a cost: bridge loans are an expensive form of borrowing because investment bankers must be compensated for the effort expended and the risk assumed. In addition, the floating rate on the loan exposes the borrower to interest rate risk if the loan is extended beyond its original maturity date. There are some strategies, however, that have been used by borrowers to attempt to-minimize those costs. Some shop around for bridge loans at reduced rates. There also has been some discussion about putting ceilings on interest rate increases over the life of the loans. Despite those tactics, the total cost of bridge financing has been estimated at one-and-one-half times the cost of normal financing. The borrower must weigh that additional cost against the benefit of additional speed, flexibility, and certainty that a bridge loan provides. BRIDGE LOANS-THE INVESTMENT BANKER'S PERSPECTIVE
Although bridge loans may originally have been used as borrowings of last resort" for companies in financial difficulties or without established track records, investment bankers now include them as part of their standard acquisition services. By providing those loans, investment bankers not only attract new clients but are better able to retain them for subsequent securities offerings and additional acquisition work.
A second (but by no means less important) benefit is that the various types of fees earned from bridge loans (and the subsequent private placement or underwriting activities) can add considerably to fees from more traditional advisory work. A typical bridge loan produces a I percent commitment fee for arranging the loan; a 1 percent fee when the loan is drawn down ("takedown" fee); interest of 3-6 percent above prime ("positive carry"); and underwriting commissions on the refinancing of 3-5 percent. Those fees are in addition to the traditional fees for services as a dealer or dealer/manager, financial advisory fees, divestiture fees for advice and arrangements for subsequent asset sales, and potential capital gains from an equity stake in the client.
One well-publicized example of the potential revenue that can be generated is First Boston's $865 million, five month bridge loan to finance Campeau Corporation's acquisition of Allied Stores. As a result of its work for Campeau on the transaction, First Boston earned:
* $47.4 million commitment fees;
* $31 million interest (at 3 1/2 percent over bank prime);
* $7 million financial advisory fees;
* $7.6 million success fee;
* $1 million for a solvency letter;
* Most of the $43.8 million in underwriting discount and expenses on the subsequent securities offering; and
* Fees on subsequent sales of Allied's divisions and refinancing of the mortgaged real estate.
The total for this "single" transaction was more than $100 million-an amount greater than First Boston's annual earnings just a few years earlier ! Bridge loan fees are high because investment bankers are taking substantial risks. One major financial risk is that the commitment made in a single transaction may represent a large proportion of the investment banker's capital. The 38 bridge-financing transactions included in SEC filings from April 1986 to July 1987 included commitments ranging from $10 million to $1.9 billion and actual loans of between $10 million and $976 million.
The bridge loan made by First Boston to Campeau illustrates the relative magnitude (and financial risk) of those transactions. For First Boston to earn the more than $100 million in fees, it committed $1.8 billion at a time when its total capital was only about $2 billion. Further, in order to raise the funds, First Boston not only had to sell its own commercial paper but also had to liquidate a portion of its own securities portfolio.
Credit risk is a second aspect of the investment banker's risk. It arises from overvaluing the assets that need to be sold to repay the bridge loan, failure to estimate accurately the time needed to refinance the loan, or adverse movements in the securities markets that affect the ability of the borrower to refinance the loan.
Bridge loans' lack of liquidity represents a third financial risk. Having such large amounts of capital tied up in a single transaction, even for just several months, can be dangerous. If the bridge loans cannot be refinanced, the investment banker is forced to hold large amounts of private, unregistered "junk" paper.
Investment banks have responded to these financial risks by instituting system of checks and balances. A thorough analysis is done of the proposed loan by a committee of industry analysts merger and acquisition specialists, corporate finance department personnel, sales personnel, and trader of high-yield securities. Senior management often must give final approval for bridge loan commitments. The process is designed to ensure that there is a clear separation between the capital devoted to trading activities and that devoted to bridge financing activities In fact, some bankers claim that the would not undertake a bridge loan unless they were comfortable that the could, if necessary, hold the loan to full maturity. Others argue that the loan are not as large as they appear: the appropriate comparison should be to total assets rather than to total capital
Despite those assurances, there is evidence that bridge loans are indeed considered risky. Investment bankers have taken steps on their own to reduce the risk of exposure in large transactions tions by seeking subparticipation on certain bridge loans. For example, Salomon Brothers provided a $300 million bridge loan to the Thompson family to help finance the buyout of Southland Corporation. This exposure, representing more than 10 percent of Salomon's total capital, was reduced to less than 4 percent by a subsequent private placement of $185 million of the loan to various commercial banks.
The potential effect of these risks on the investment bank's credit quality is becoming more apparent. Last year, for example, Moody's announced that it had downgraded Merrill Lynch's senior debt, partly because of the higher risk resulting from more extensive commitments of its own capital. Standard and Poor's has advised companies about the amount of capital that they may risk before their existing credit rating is threatened.
Another recent example clearly demonstrates the risks faced by investment bankers when they make bridge loans. In April 1987, Salomon made a $275 million bridge loan to TVX, a broadcast company, for the purchase of five independent television stations from Taft Broadcasting. TVX's financial condition deteriorated after the acquisition as a result of the continued weakening in the independent television industry. Those financial problems, coupled with the October stock market crash, made it impossible for Salomon to refinance the bridge loan with junk bonds. Salomon subsequently waived further interest payments on the bridge loan, extended the loan's maturity twice, and invested another $1 0 million to keep TVX in business. Salomon placed three of its representatives on TVX's board and agreed to a recapitalization plan under which it would buy $135 million of convertible preferred stock (at a price more than double the market price); would privately place $210 million of notes that Salomon would buy if they couldn't be sold; and would invest an additional $20 million of working capital. This plan, while replacing the bridge loan with permanent financing, left Salomon as a 77 percent owner of TVX. POTENTIAL CONFLICT OF INTEREST
The major non-financial risk associated with bridge loans is the potential conflict of interest that arises when an investment banker acts simultaneously as creditor, equity participant, underwriter, and financial advisor. Can the investment banker retain the ability to meet its responsibilities as an advisor while providing financing to help ensure that the transaction is completed? Do investment bankers, as bridge lenders, advise clients to take on unnecessary, expensive financing that the bankers themselves are providing?
The conflict-of-interest issue has been raised both by members of Congress and by the Securities and Exchange Commission (SEC). Representative John Dingell, chairman of the House Committee on Energy and Commerce, has spoken quite often about the potential problems created by investment bankers' active participation in clients' financial affairs. Nevertheless, a 1987 study completed by the SEC staff at Rep. Dingell's request concluded that existing statutory and regulatory disclosure requirements concerning bridge financing are adequate to protect the securities market and the public. Under various Federal securities laws, filings made by bidders in tender offers, leveraged buyout participants, and firms in registration statements must include substantial details concerning the terms, parties, and fee arrangements in connection with bridge loans. SEC rules relating to brokerdealers' net capital requirements and anti-manipulative practices, as well as the Fed's margin requirements and the NASD's regulation of underwriters, help various federal regulatory agencies monitor bridge loan activity.
The staff, however, did recognize the potential for significant conflicts of interest when a firm has a bridge loan outstanding: the possible lack of either objective pricing for securities being used to repay the bridge loan or objective recommendations to its customers about buying those securities. Such concern has led the SEC and the NASD to adopt a rule requiring an investment banker to employ an independent underwriter to set the price, prepare the registration statement, and conduct the due diligence review when the investment banker serves as advisor and also has a significant financial stake in the success of the offering (if 10 percent or more of the proceeds will be used to repay a bridge loan made by the investment banker, for example).
A different type of conflict of interest surfaced in one hostile takeover. Shearson Lehman, in addition to a $500 million bridge loan commitment, acquired 46 percent of a company formed by C.H. Beazer, a British building group, as part of a planned hostile takeover of Koppers, a Pittsburgh-based chemicals and building material company. The equity bridge loan," which was to be temporary, was controversial not only because of the investment bankers' equity participation in a hostile transaction, but also because Shearson had underwritten some of Pittsburgh's municipal bonds. The city of Pittsburgh sued both Shearson and its parent, American Express, for this alleged conflict of interest. The city claimed that Shearson had a duty not to take any action that might impair the sale of its bonds. The suit alleged that the responsibility was breached because the takeover could harm the city financially. In addition, the Pennsylvania State Treasury suspended its investment banking activities with Shearson to protest the possible loss of jobs in the state.
his article has described bridge
financing provided by investment
bankers to their merger and acquisition clients. Buyers view these loans as a quick, flexible way to satisfy sellers that financing is in place. Investment bankers view bridge lending as an extremely profitable way to employ capital and as a device to attract and retain clients for future underwriting and more traditional advisory services.
The dangers inherent in bridge lending have also been well publicized. Having large amounts of capital tied up until the bridge loan is refinanced exposes the investment banker to many risks: the credit risk of the borrower, the subsequent refinancing of the loan, and the reduction of liquidity. The potential conflict of interest in such situations has also been well documented. When an investment banker, in addition to providing financial advice to a client, is also a large creditor, the objective judgment of the banker-advisor might be biased for the benefit of the banker-creditor rather than for
Despite the dangers, bridge lending is becoming a permanent part of many investment banks' product line. Some view bridge loans merely as an initial step in the search for ways to use investment bankers' greatly enhanced capital bases profitably-part of a trend toward merchant banking. Others are concerned that pursuit of the large fees that can be earned by providing bridge loans (and by merchant banking practices in general) will interfere with the overall goals of the investment banking firm.
The availability of bridge loans may also be contributing to the recent wave of speculative, highly leveraged takeovers by making it easier for corporate raiders to put targets in play. That is, the offers of corporate raiders are made more credible by the availability of bridge loans. Risk arbitrageurs (including trading desks at some investment banks) invest heavily in takeover stocks. Because the arbitrageurs often accumulate large positions in target company stocks, the sale of the company or a defensive strategy by the target can become a self-fulfilling prophecy.
Despite calls for increased regulation, many investment banks will undoubtedly continue to make bridge loans to their merger and acquisition clients because of the large potential profit. Nevertheless, curbs on bridge financing will come from the market itself: the potential for loss from making increasingly large and more frequent bridge loans is well recognized. Additional legislation may be necessary to deal effectively with the conflict of interest problems that inevitably result when the wall separating merchant and traditional investment banking activities crumbles. 71
1. This article uses the general term acquisition to include tender offers, mergers, leveraged buyouts, and other acquisition-related transactions.
Anthony Bianco, "Wall Street is Solid-But Very Nervous," Business Week, January 12, 1987, p. 110.
Daniel Hertzberg, "Wall Street Dealmakers Boost Their Takeover Risk," Wall Street journal, July 6,1986, p. 6.
Elliott Lee, "Salomon Finds that There Are Pitfalls When Investing in Unfamiliar Markets," Wall Street journal, june 14, 1988, p. 7.
Peter Lee, "View From Bridge Makes Bankers' 'Heads Spin," Euromoney, May 1987, pp. 64-73.
Martin Lipton, "Corporate Governance in the Age of Finance Corporatism," University of Pennsylvania Law Review, November 1987, pp. 1-72.
Securities and Exchange Commission, Divisions of Corporate Finance and Market Regulation, Bridge Financing Transactions Involving Affiliates of Investment Banking Firms, April 8,1987.
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|Title Annotation:||bridge financing, as source of revenue for investment bankers, poses risk and conflict of interest|
|Author:||Glazer, Alan S.|
|Date:||Sep 1, 1989|
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