Some notes on Leveraged Financing in China

White & Case
China: Future of Leveraged Transactions in China
25 February 2007
Article by Fred Chang

Leverage Not Taboo

The requirement for a high level of leverage to finance a project is neither unusual nor taboo in China, and there has in the past been no shortage of willing borrowers, lenders and (most importantly) approval authorities keen to execute leveraged transactions.

However, most of this activity has been in the context of transactions generating tangible assets such as new plant and infrastructure. This is now being extended—with the enthusiasm of all concerned—to the consummation of structured financing transactions designed to finance the origination and carrying of financial assets such as loans, rentals and trade receivables. So does a thriving economy continue to expand.

In China, however, the exuberance for leverage has not so far extended to corporate takeovers. It is one thing for the government partially to divest its holdings in state owned enterprises, accompanied by injections of new equity capital into the SOEs to fund capital expansion, in IPOs and strategic investment transactions. It is another thing for the government to acquiesce in the change in control of Chinese companies where the would-be acquirer (particularly if it is a foreign entity) has one of two motives (in the mind of the government): housecleaning or exit. The government would rather have it both ways. The existing personnel and business should be what remains at the end of the day and the acquirer should increase the going-concern value of the company by "reforming" both those people and the business that it acquires1. For these purposes, the word "acquirer" refers to a foreign-organized acquirer of more than 50% of the voting stock of a Chinese company that is (or is the largest shareholder in) a listed2 Chinese company, and "takeover" refers to a transaction which leads to that result.

This article examines, in relation to listed companies: (a) the reasons in favor of at least some types of takeovers, and; (b) the methods by which takeovers can utilize leverage to enhance the acquirer’s incentives. Being an area that has not yet been tested, leveraged takeovers in China present a set of risks which this article briefly analyzes and attempts to quantify.

Takeovers Not Considered Intrinsically Valuable
A takeover for its own sake lacks appeal to the Chinese policy-makers, since no asset is created. Indeed, where the company is state-owned, simply to give the government funds in exchange for control of the company begs (in the view of the government) the twin questions of: (a) how to reform the company, and; (b) how to define the government’s ongoing role in the economy.

Company boards owe a fiduciary duty to their shareholders. There are certain types of company, however, that owe fiduciary duties to other constituencies as well. For example, financial institutions that take Other People’s Money, at least when Other People means the retail public, owe fiduciary duties to depositors, policy-owners, and brokerage and fund investors. In the shiny world of theory, the State as owner of a financial institution has the best interests of all its citizens, including the Other People whose Money such financial institution controls, at heart. But this theory culminates in the concept of financial institution as shadow tax collector.

It creates conflicts between the purely financial motivations of the people whose residual income is placed in financial institutions and the fiscal (or less salutary) motivations of the central and local governments that are the owners of such financial institutions. Although the Guangdong Development Bank ("GDB") transaction could not be approved as a takeover, there is nothing to say that this situation could not change in the future. Indeed, the financial services sector is an area that, a priori, is best run professionally rather than by the state. However, such a development is likely to unfold as an iterative process, as the provision of credit is a highly sensitive industry where: (a) the alternative methods of capital raising, such as bond and stock markets as well as private placements, are still embryonic, and; (b) the need to fund capital expenditures is still critical.

A second area where takeovers may be welcome is for companies in distress (yet, for purposes of leveraged takeovers, have positive book net worth). It is important to bear in mind that the shareholders of the target company will be likely to include as a majority various governmental entities, and that for the foreseeable future, the motivations of such shareholders are not those typically prevalent in Western economies. The conventional wisdom of having a three-pronged arsenal to mitigate the risk of fundamental disagreement with management (proxy battles, derivative suits and the ability to exit positions in the stock market) is not very relevant in China—for the foreseeable future it is these governmental entities that will be left holding the bag for failed management of significant enterprises, whether as stockholders or otherwise. The pool of management talent that understands how to sell goods and services in China is not yet deep enough to support a full-blown market for corporate control. There is little interest, as yet, in having debates about corporate policy play out in the Chinese securities markets. Rather, it is when there is nothing left to debate, as in the case of a chronically unprofitable company, that a takeover begins to make sense, a posteriori.

A third area is street sales. These must be approved, or taken up in a purchase, by a majority of the other shareholders—by a controlling shareholder in a company that is not state-owned, such as street sales of interests in Sino-foreign joint ventures or in privately owned enterprises for purposes of converting to "FIE" status (generally, a tax-favored domestic enterprise with 25% or greater foreign ownership). This has been an active market of late, but because this article is concerned with changes in control involving listed companies, it is not further discussed here3

Perhaps most fundamentally, there may be some industries in which, far from wanting more plant and infrastructure creation, the policy makers would like to see less—i.e. a corporate consolidation and weaning process that is the cauldron out of which national champions in such industries may be born.

Foreign Takeovers Legally Possible
The two leading precedents are the pending acquisitions (not "takeovers") of Guangdong Development Bank ("GDB") and Xugong Group Construction Machinery Co Ltd ("Xugong"). That they are not takeovers should not be disheartening for acquirers. These targets displayed only some and not all of the optimum conditions for permitting a takeover. While they are both companies in need of improved competitiveness, in "bedrock" industries (banking and construction machinery) as a whole that are also in need of improved competitiveness: (a) GDB is in an industry in which conversion to "foreign invested" status (greater than 25% foreign ownership) entails certain legal consequences which the banking regulator (the China Banking Regulatory Commission, or CBRC) would consider ‘prudentially’4 unacceptable, and; (b) Xugong5 is in an industry considered6 (rightly or wrongly) by observers to be sensitive to national security. In other words, these and any other proposed takeovers of companies in industries which do not forbid majority foreign ownership as a matter of law under the post-WTO accession rules may only be stopped at the discretion of the approval authorities.

What a Leveraged Buy-Out ("LBO") by a Foreign Sponsor Might Look Like
We turn to the methods by which it may be possible to enhance the acquirer’s financial incentives through the use of leverage. A high degree of leverage is typically not available on arms length commercially reasonable terms unless the leverage provider is contractually or structurally senior to general unsecured creditors of the owners of the most valuable corporate assets. The challenge of LBOs lies in the fact that the acquirer typically owns only stock and can only own valuable collateral by way of mergers, and absent such mergers, the acquired company and its subsidiaries must approve the grant of security to the leverage provider. We contemplate the following hypothetical situation, which similar in some but not all respects to what is known publicly about the Xugong transaction:

The target is an unlisted PRC incorporated company ("Target") that owns (among other things) a substantial though not necessarily majority stake in another PRC incorporated company ("Listco Sub") that has A shares listed in China, as well as other unlisted subsidiaries in China (collectively, "Target Group"). Target is indirectly majority owned by the government by virtue of the government’s ownership of the majority owner ("Parent") of Target. Target operates in an industry which, post-WTO accession, does not prohibit majority foreign-owned companies. The acquirer is ultimately owned by a highly creditworthy foreign entity that meets the qualifications applicable to foreign strategic investors in listed companies set out in the Strategic Investor Rules, but neither the acquirer nor such foreign entity is, or is affiliated with, a QFII. Neither the acquirer nor the foreign entity has appreciable sales in China. Target Group has steady revenues primarily from domestic sales, and has little financial indebtedness relative to the book value of its assets (or at least would remain solvent after giving effect to indebtedness incurred by Target Group members in connection with the takeover). Target Group has substantial assets comprised of plant, property and equipment, inventory, trade receivables, and/or bank accounts.

Acquirer and Parent agree that acquirer will acquire X% of the fully diluted equity (the "Stock") of Target from Parent for a price of RMB equivalent of $A (the "Acquisition Price"). Under the CSRC’s Administrative Procedures for the Acquisition of Listed Companies (effective September 1, 2006) (the "Offer Rules"), unless an exemption is granted by the CSRC, the maximum interest in a listed company’s "issued shares" that can be acquired (directly, or indirectly by acquisition of the Stock) by negotiated purchase is 30%. Any excess over 30% must be obtained by means of a general or partial (i.e. for 5% or more) tender offer. See Articles 47 and 61.

Alternative Structure A: 80% of the Acquisition Price will be funded by a loan ("Loan") from a bank ("Bank")7 booking through one of its offshore offices, that has a branch (or subsidiary) ("Branch") in China.

Acquirer, foreign entity, Parent, Target Group members, and Bank and Branch enter into a participation agreement ("PA"). The key provision of the PA is the agreement of the parties that: (a) the Acquisition Price is paid to Parent and Parent will hold the Stock "in trust" for the acquirer (which remains the exclusive beneficiary of all indicia of economic ownership including dividends (after all required debt service), voting rights and the right to transfer the Stock); (b) disbursement by Branch, at the instruction of the acquirer, of the proceeds of the Loan (to the Parent) and other drawdowns under a secured credit facility ("Secured Facility") between Branch and Target Group members (to Target Group members) is consideration for the grant of security over the assets and cross-guarantees of the payment obligations of various members of Target Group in favor of Branch; (c) payment to Branch by Target Group members is good discharge, to the extent of such payment, of required debt service on the Loan and other indebtedness under the Secured Facility; (d) there is no recourse to Parent for any obligations under the Secured Facility, except that the Parent indemnifies Branch against any losses suffered as a result of the deliberate violation of covenants8 under the "trust" arrangement, and; (e) the foreign entity agrees to pay Bank the difference between required debt service under the Secured Facility and amounts actually received by Branch from free cash flow of Target Group (as well as after enforcement of rights), unless that difference is due to the deliberate breach of Parent’s obligations under the trust arrangement.

The key role in this transaction is that of Branch. Branch must be willing and able to carry the amount of the exposure under the Secured Facility (a RMB asset) on its books, with or without funding from Bank. There is also a currency mismatch between the Branch’s loan assets and the "investment" in the Branch by Bank in such amount.

Alternative Structure B: 70% of the Acquisition Price is funded by an unsecured USD bridge loan to the acquirer (guaranteed by the foreign entity9) from one or more offshore lenders. This loan is refinanced ("Prepayment") by a dual currency (USD/RMB) loan facility from one or more domestic lenders (the "Secured Facility"), under which Target (as surviving corporation in a merger (the "Merger") by acquirer into Target that marks the termination of the bridge facility and of the effectiveness of the Secured Facility) and other Target Group members may draw, which is cross-guaranteed by all Target Group members, and which is secured by all Target Group assets. The Target draws an amount equal to the Prepayment under the Secured Facility, while other Target Group members draw on the Secured Facility from time to time for working capital needs. Funds might also be available to make payments necessary to cash out certain shareholders of Target Group members as discussed in "CSRC Risks" and "Risks Under Company Law" below, to the extent such cash outs (as conditions precedent to drawdown/release from escrow) are not funded by internal cash.

In Structure B, the foreign entity remains on record as ultimate owner of Target and Listco Sub, and there may be significant upfront cross-border debt service flow (the Prepayment) and the potential for complex inter-creditor negotiations in connection with the Merger (see discussion in "Risks Under Company Law" below). The refinancing and Merger10 are for the purpose of avoiding concerns about using domestic bank funds to acquire Stock, and banking law and corporate benefit concerns if the borrower of the domestic bank funds is a foreign entity that is not a Target Group member. Structure A avoids these potentially troublesome aspects, subject to the risks discussed in the last paragraph of this article.

Risks: The Lenders’ post-drawdown risks in these structures can be summarized as follows:
CSRC Risk: This is the risk that the CSRC do not waive the requirement that acquirer must make a partial or general offer for any part of the shares of Listco Sub indirectly to be acquired that constitutes an excess over 30% of the issued shares. In this event, since acquirer itself has no power to purchase and own A shares in its own name, it would have to "entrust" a party, such as Target, to make the offer and hold the A shares in trust for acquirer.

Risk Arising from Conversion to FIE Status: By virtue of the takeover, Target has (at least under Structure B and probably A as well) become an FIE, a conversion which requires approvals from a host of regulatory bodies—the NDRC, MOC, SASAC, SAIC, SAFE and the Tax Bureau, at either central or local levels depending on the transaction—and while these approvals are generally given so long as the formal requirements for investment and documentation are complied with, the MOC in particular retains discretionary authority to disapprove transactions on various grounds such as national/economic security and harm to competition. However, most of these approvals can be made conditions precedent either to drawdown or to release of funds from escrow, with the exception that 20% of any additional equity contribution to Target in relation to Target’s conversion to FIE status (if acquirer subscribes to an increase in capital of Target) is required before a business license will be issued to the FIE, and certain tax procedures required to permit dividends to flow offshore cannot be finalized until the monies are released to the Target or Parent.

Bankruptcy and Perfection Risk: If a Target Group member becomes insolvent within one year after its grant of security, that grant could be rejected to the extent given for inadequate value, under Article 31 of the Bankruptcy Law, with the result that in relation to the obligations of that Target Group member, the lenders would hold only general unsecured claims. The perfection of security interests in rights and in bank accounts is also uncertain. However, registration is possible at the local notary public in relation to the former (per a ruling of the Ministry of Justice), and the consent of the account debtor (in the case of the former) and acknowledgement of the account bank (in the case of the latter) would pre-empt rival claims of other creditors absent deliberate breach by the account debtor or account bank (in which event a claim would arise against those parties).

Risks Under Company Law: Subject to the possibility of cashing and or merging out dissident shareholders of any given Target Group member security grantor, (A) the use of corporate assets to secure the borrowing by upstream entities (as opposed to own borrowings) must be approved by a majority11 of shareholders (exclusive of shareholders that are the borrowers) present at a shareholder meeting of each Target Group member providing collateral. These approvals should, if possible, be made conditions precedent to drawdown; and (B) for the Merger, in addition to approval of two thirds of the shareholders present at a shareholder meeting, the non-objection (within the later of 30 days after actual notice or 45 days after publication in a newspaper) of creditors of Target is a condition to the effectiveness of the Merger. Objecting creditors have a right to prepayment or equal and ratable security. A cash-out could be funded with internal cash as a condition precedent to drawdown or through draws on the Secured Facility as a condition subsequent. Whether or not a cash-out is necessary, the all-in costs of the financing would rise, either to pay the guaranteeing companies some consideration (e.g. guarantee fee) or to increase the amount of group stock being purchased.

Risks Under Banking Law: This is the risk that the Secured Facility in Structure B would be recharacterized as a loan extended to finance the acquisition of shares, which is prohibited.

Liquidity, Currency and Political Risks Relating to Branch Investment: This is exacerbated by the recent State Council Decree No. 478 Administrative Provisions Applicable to Foreign Funded Banks (effective December 11, 2006), which requires branches of foreign banks wishing to engage in either credit card or retail RMB-denominated business to re-incorporate in China. Whereas in the past Bank and Branch were one accounting entity (regardless of the Bank’s internal policies on quantifying the political/inconvertibility risk of its capital in China and regardless of Chinese banking laws requiring each branch of a foreign bank to adhere to capital requirements on a standalone basis), banks that wish to engage in such businesses can no longer be so. Bank’s overall cost of capital will increase (if it intends to engage in such businesses) compared to what it would have cost to maintain a similar asset in the branch prior to the effectiveness of the new law. Presumably this will be charged through in the interest rate on the Secured Facility.

Risk that Entrustment Arrangements not Enforceable Against Entrusted Party: Generally, under the PRC Contract Law, a contract (including its remedial provisions) will be enforceable against the obligor thereunder so long as adequate consideration has been given for the obligation and the performance of that obligation does not violate law. Since the Parent received the proceeds of the Loan, adequate consideration for its obligations under the PA would have been given. The question is whether the acquisition, financed by domestic bank loans, of control of the Target and, indirectly, Listco Sub and other Target Group members, by a foreign entity would be considered a violation of PRC law. Given the hypothesis of non-prohibition under the Catalogue of Foreign Investment, and the formal features of Structure A, in which it is not the acquirer that is the actual borrower of domestic bank funds but other parties, such an argument by Parent and Target seeking to abrogate the trust arrangement, either in a distress situation or due to fraud/willful breach, should not succeed12 However, the risks of fraudulent preference, failure to close necessary post-drawdown corporate approvals (as for cash outs of dissidents or post-drawdown mergers), or failure of the foreign invested enterprise to obtain required licenses and approval for continued operation could be further mitigated through an escrow of the Acquisition Price—unlike the case of the LBO of a public company, which would be mechanically impossible to unwind, it would not be mechanically difficult to unwind the escrow of Parent’s funds.

As can be seen from this brief analysis, potential structures exist for leveraged takeovers within China. Associated with these is a set of risks that, in the main, are both identifiable and quantifiable and which can be addressed in the deal structure. These should not in this writer’s view, in principle, discourage those considering a more fundamental level of participation in the mainland economy through the use of LBOs.

The author gratefully acknowledges the assistance of Zhao Ying and Li Yongyi. Ying is a lawyer in White & Case’s Beijing office and Yongyi will join White & Case’s New York office in September.

© 2007 White & Case LLP

EBLs are bad news for underwriters

Concerns grow over risky equity bridge loans
By Michael Flaherty

NEW YORK, June 14 (Reuters) - The recent popularity of a risky private equity financing agreement, known as an equity bridge loan, is raising concerns among analysts, regulators and even the bankers who arrange them.

Equity bridge loans allow private equity firms to get investment banks to share in the cash payment on deals. Such loans are great for buyout firms wanting to pursue takeovers without joining forces with competitors, but carry huge risk and skimpy pay-offs for the investment banks.

While this type of lending has been around for decades, the size and frequency of the loans has risen to the point where Goldman Sachs has told its mergers and acquisitions staff to avoid them, according to a banker who works there. Goldman declined to comment about its policy.

The Ontario Teachers-Providence Equity Partners group pursuing Canadian telecoms group BCE Inc. is asking investment banks to pony up a roughly $4 billion equity bridge, leaving the banks on the hook for about $800 million each, according to two people involved with the deal.

That's a staggering amount of exposure given that just last year, the equity bridge commitments for buyouts of media companies Univision and Clear Channel Communications Inc. , which ranged from $100 million to $350 million, were deemed large, according to sources involved with the deals.

"Equity bridges are a really bad business," said an investment banker who arranges private equity deals. "You have a very small amount of reward for a huge risk. But people are doing them because it's forced on them in terms of being competitive. The pain is going to be immense if one of these bridges falls apart."

The best-case scenario is that the investment banks quickly sell the equity exposure to other buyers. But even then, banks typically earn only a 1.5 percent return on the loan. That means for risking $500 million, they earn just $7.5 million.

The worst case is that banks can't sell down the equity. Then they are left holding the bag, in some cases with hundreds of millions of dollars in exposure.

Chief executives, credit officers, strategists and investment banking heads are all signing off on these loans. Bankers interviewed for this article say a tremendous amount of time is spent dissecting deals before handing over a big check. Some say no to equity bridges.
But bankers also admit that the private equity players -- whose deal frenzy is throwing off billions of dollars in fees for Wall Street -- call the shots, and equity bridges are simply the price you pay to play with them.

"It concerns us every day," said JP Morgan global equity strategist Abhijit Chakrabortti, referring to the rise of equity bridges.
Chakrabortti, speaking at the Reuters Investment Outlook Summit this week, said while JP Morgan keeps a close eye on these loans, he does not see any near-term pull-back that would hit the leveraged buyout (LBO) market. Private equity firms buy and sell companies, borrowing most of the money to finance the deals. Frothy debt markets have fueled the current LBO wave.

"You always need a catalyst and we're not convinced that yields or the interest rate outlook is at that level where we're going to get that hit," he said.

Indeed, LBO deals are still being pumped out with no end in sight. But the growing prospect of interest rate rises has led some analysts to believe the frothy debt days are numbered.

The heavy borrowing and risky financings fueled by cheap debt have not escaped the attention of U.S. Federal Reserve Chairman Ben Bernanke.

"There are some significant risks associated with the financing of private equity including bridge loans," Bernanke said last month. "We are looking at that."

Equity bridge loans appeared in the late 1980s but then went dormant, for the most part. They became popular again late last year when private equity firms started pursuing larger companies on their own, or with one other LBO partner.

Citigroup and RBS Securities arranged an equity bridge of $450 million in a $25 billion LBO of wireless company Alltel Corp. , according to a proxy filed on Wednesday.

Morgan Stanley , Citigroup and JPMorgan have offered a $1 billion equity bridge in an LBO offer for Texas utility TXU Corp. .

An equity bridge was also part of a proposed $17.1 billion buyout of casino company Harrah's Entertainment Inc. .

"It's just further evidence that the private equity folks are calling the shots," said Tom Marshella, a managing director in leveraged finance for credit-ratings agency Moody's Corp.

"It's astonishing the degree of risk they're able to lay off, including underwriting the equity. I haven't seen anything like this in the (11 years) I've been involved with leveraged finance."

CDS may be the financial innovation that will reduce credit spreads permanently

Credit default swaps are fast becoming a cost-effective means of transferring credit risk as well as leveraged financing hedging strategy.

Loan Credit-Default Swaps May Exceed Loan Trades (Update2)
By Patricia Kuo and Junko Fujita

June 20 (Bloomberg) -- Credit-default swaps linked to loans will be more actively traded in the U.S. than the loans themselves within a year, according to analysts at Citigroup Inc., the largest U.S. bank.

Trading of loan credit-default swaps now accounts for 50 percent of the volume of loan trades handled by Citigroup, New York-based Jonathan Calder, head of the U.S. bank's loan sales and trading, told a conference yesterday in Tokyo.

``It's an easy bet that over next year, loan credit-default swaps will exceed cash loan trades volume by at least two times,'' Calder said at the conference organized by New York- based Loan Syndications and Trading Association.

Credit-default swaps on loans, used to speculate on the ability of companies to repay the debt, are luring investors such as hedge funds and fund managers as a lower-cost alternative to investing in loans. They also provide arbitragers with opportunities to profit from the gap in risk premium between loans, derivatives and bonds.

The amount of loan credit-default swaps outstanding has ballooned to more than $85 billion from $31.6 billion last year and $6.3 billion in 2005, according to estimates from Goldman Sachs Group Inc. and Markit Group Ltd., administrator of the LCDX index, the first tradeable index contract tied to the loan market.

The amount traded on the LCDX index, based on the loans of 100 companies, reached $25 billion in its first two weeks, according to Markit. Goldman estimates that about $60 billion in credit swaps tied to individual companies were outstanding before the index started trading.

First Data
Arrangers of the non-investment grade loans that Kohlberg Kravis Roberts & Co. is seeking for its takeover of First Data Corp., the world's largest card payment processor, may start selling the debt in the next few weeks. Credit-default swaps on the loans, which haven't yet been sold, are already actively traded, Calder said.

Greenwood Village, Colorado-based First Data said in a regulatory filing in May that New York-based KKR will seek $16 billion of loans to fund the acquisition.

``This is not just an evolution. This is something that will significantly change the way we do business,'' Calder said.

$40 Billion Trade
Traders have bought an estimated $40 billion of loan credit- default swaps as part of what is called a negative basis trade, Calder said. In such a trade, investors can profit from holding both a loan and its protection against default when the cost of the derivative contract is less than the interest income they get from the loan.

The loan's yield premium over the cost of protection -- which ranged between 30 basis points and 120 basis points in the U.S. this year -- will probably disappear once the commercial lending departments of banks start purchasing credit-default swaps based on loans they've made, he said. A basis point is 0.01 percentage point.

The funds might leave the U.S. loan market should investors reverse these trades, Calder said.

``At the moment, cash is flowing into loans to do the negative basis trade,'' Calder said. ``At some point in the future, cash may flow out of loans.''

`Move the Market'
Even loan investors who don't use credit derivatives should learn about this trade because it is big enough to affect the loan market, Calder said.

``The size associated with that potential flow is enough to move the market,'' he said.

Credit-default swaps tied to corporate bonds, which were conceived about a decade ago, more than doubled in 2006 to cover $34.5 trillion in securities, according to the International Swaps and Derivatives Association. That's almost 10 times the amount of senior unsecured bonds outstanding. Credit swaps were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

The record amount of money sought to finance buyouts may cause borrowers in the U.S. to pay more for non-investment grade loans by the end of the year, Calder said. Standard & Poor's Leveraged Commentary & Data unit estimates that companies will seek about $197 billion of junk-rated loans in the next 12 months.

That concern is reflected in the LCDX index. The index fell for a seventh day, declining 0.30 to 99.74 at 4:03 p.m. in New York. The index is below 100 for the first time since May 22, according to Markit Group. A decline in the index signals deteriorating perceptions of creditworthiness.

Leveraged Loans
Leveraged loans in the U.S. grew 85 percent to $550 billion this year compared with the same period of 2006, Bloomberg data show.

``With the large size of individual deals and large aggregate calendar, we expect there will be some backup in the rates in the U.S. leveraged loan market as we go through the summer,'' Calder said. ``We're going to have the busiest summer and I will be very surprised if we don't see coupons expand a little bit.''

Banker cautions on risks of leveraged financing

UBS chief warns over lending boom risks
By Peter Thal Larsen in London and Haig Simonian in Zurich

(FT June 19) The chief executive of UBS, the Swiss banking group, warned that the growing number of risky loans investment banks are making could lead to lawsuits and damaged reputations.

The warning by Peter Wuffli highlights increasing concern among senior executives that a boom in leveraged finance could drag banks into litigation and damaging disputes with clients if the credit cycle turns.

His comments, in an interview with the Financial Times, are the latest in a series of warnings by investors, bankers and regulators about loose lending standards, typified by rising amounts of leverage and the growing use of “cov-lite” loans, which lack the usual safeguards for lenders.

Mr Wuffli compared the potential consequences of the lending boom with the fallout from the stock market bubble of the late 1990s, when investment banks became embroiled in a series of accounting scandals and regulatory investigations that proved more damaging than their financial losses.

Banks that underwrite large loans typically reduce their exposure within a few months by parcelling up the loans and selling them to other investors. But Mr Wuffli said there were broader considerations: “This is potentially risky in terms of exposure to litigation, exposure to quarrels, or just plain exposure to reputation,” he said. “So financial institutions that think long-term, such as ours, do perceive a certain responsibility that includes deal terms, leverage, quality of the deals and so on.”

His views are shared by other bank executives involved in leveraged finance. “Holding your nose while you’re doing the underwriting and lending is fine if you’re just passing through town,” said the chief executive of one European bank. “But if you plan to be there any period of time, selling duff loans is not a great recipe for good business.”

UBS has been cautious about leveraged finance, though it has relaxed its lending criteria and accelerated its decision-making to put itself in a better position to compete for business with private equity groups.

Banks are under pressure from private equity groups and other borrowers to loosen lending standards, while investors are demanding exposure to products that offer an attractive return.

Some bankers fear that the growing use of “cov-lite” loans could complicate the restructuring of troubled companies by allowing them to continue operating for longer before they default.

However, others believe the loans offer borrowers greater flexibility, which will allow them to weather economic cycles.

Large private equity groups have also asked investment banks to put more of their capital at risk by underwriting portions of the equity in deals. Banks are being asked to put up short-term “bridge equity” as a condition for being allowed to participate in financing buy-outs.