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In the five years leading up to the credit crisis, investment banks' financial sponsor groups were one of the brightest spots on Wall Street. Serving private equity firms and their portfolio companies, these groups were at the center of some of the largest deals in history, collecting fat fees for doing everything from advising on giant buyouts to leading deal-related bank loans and bond financings to underwriting initial public offerings when PE shops looked to cash out of their investments.
Now many of those fees have thinned out or have gone away entirely as the megabuyouts that enriched so many have vanished. A big deal today falls in the $1 billion to $2 billion range, as many sponsors put their money to work through noncontrol investments -- a far cry from the record-breaking $45 billion buyout of Texas utility TXU Corp., now Energy Future Holdings Corp., that TPG Capital and Kohlberg Kravis Roberts & Co. completed last year. Making matters worse, investment banks, saddled with debt they cannot sell, are battling with some of their private equity clients over the borrower-friendly buyout loans conceived during the boom, with one of the most public examples the $23 billion buyout of Clear Channel Communications Inc. by Bain Capital LLC and Thomas H. Lee Partners LP. A dispute over the financing agreement led by Citigroup Inc. and Deutsche Bank AG was argued in court before a settlement was reached in mid-May. "I doubt that there has been such a trying time for the banks and sponsors," says Mark Bradley, head of global financial sponsors at Morgan Stanley. But now financial sponsor bankers say they are beginning to see the light. They say they are once again engaged in constructive dialogues with their sponsor clients, who are hungry to put their investors' money to work -- though financing is still difficult and targets few and far between. The landscape requires creativity as bankers seek new ways to help build on sponsors' existing platforms as well as innovative ways to finance their deals. Several are also looking to Asia and sovereign wealth funds as new sources of business. And as the backlog of committed bridge loans on banks' balance sheets continues to clear -- it's down to $80 billion to $90 billion from a peak of more than $300 billion late last year -- bankers are optimistic that the leveraged buyout market is set to recover soon. "We'll get back to a healthy place," says Steve Smith, the head of UBS' sponsor group for the Americas. Banks and buyout shops, meanwhile, continue to battle over the financings for boom-time deals, including the C$52.3 billion ($52.5 billion) buyout of Canadian telecom BCE Inc. That has some lenders believing a new balance between banks and their financial sponsor clients is necessary. In the past, there were three winners in a private equity deal: seller, buyer and banker, saysCredit Suisse Group 's global sponsor group head, Harold Bogle. After a transaction was completed, all benefited from the terms, since the market dynamics remained unchanged from the time the deal was signed. But today that is no longer the case. "For the first time, for as long as I can remember, there have been one or more losers at closing," Bogle says, adding that the risk sharing has shifted too far to the banks. To limit the potential for losses, Bogle believes banks must evolve their model and perhaps introduce greater price flexibility to ensure they can sell their debt commitments or insert a breakup fee for their protection. As Brad Coleman, head of financial sponsors at Citigroup, puts it: "We'll have to find a new equilibrium." For the investment banks, much is at stake when serving the financial sponsors. Last year, for instance, Goldman, Sachs & Co., pocketed $1.5 billion in fees from its financial sponsor business, making it the industry leader. J.P. Morgan and Credit Suisse were next, with $1.3 billion and $1.1 billion, respectively, according to research firm Dealogic. "The sponsors knew it was an unusual time," says Alison Mass, co-head of Goldman's financial sponsor group for the Americas. Goldman and other banks today are clearly not expecting to rake in the same gigantic fees. "It's going to be dramatically less in 2008," says Credit Suisse's Bogle. And so far it is. Across Wall Street, investment banking revenue from sponsors plummeted 77%, to $1.5 billion, in the first quarter of this year, according to Dealogic. Fees from leveraged loan financing took a steep 81% dive, to $55 billion, while dividend recapitalization loans all but disappeared, dropping 99%, to $477 million, from $33 billion in the first three months last year. Overall, buyout firms are contributing a smaller piece of banks' revenue. In the first three months of this year, they accounted for 9% of global investment banking revenue, down from 22% in the first quarter of 2007. In the U.S., buyouts saw the largest drop on record. They totaled $15.5 billion, down a stunning 85% from $101.3 billion the same quarter last year. Some banks have viewed the trying times as a chance to win over clients whose relationships with the competition have been stressed or broken due to the credit crisis. UBS is one of them. "A lot more people have shown interest," Smith says. At Morgan Stanley, Bradley reports that while a couple of sponsor relationships were fractured during the credit crisis -- the firm had about 25 deals with sponsors outstanding when the credit markets completely fell apart last year -- about five have since been "greatly enhanced." And at Goldman, sponsor relationships are "as good or better today than pre-credit crisis," Mass says. "If anything, we've increased dialogue with clients," adds Milton Berlinski, Goldman's global sponsor group head. Goldman has no plans to shrink its sponsor coverage, which includes both large and middle-market firms. The number of its midmarket clients has risen considerably over the past five years, its bankers note, now accounting for 30% to 40% of its sponsor business. It's still early in the year, but in the first quarter Goldman kept its No. 1 ranking in the business. It grabbed 11.1% of market share with $128 million of revenue, according to Dealogic. Still, that was 67% lower than the $394 million it realized in the same period last year. Goldman is not alone in spending more time targeting middle-market buyout shops. One year ago, Deutsche Bank hired Justin Abelow from Houlihan, Lokey, Howard & Zukin Inc. to help build its midmarket sponsor client base. In addition to looking for smaller deals, many financial sponsor groups are also positioning themselves to grab market share in Asia, where dealflow, though relatively small in terms of total M&A volume, has not felt the dramatic impact of the credit crunch. J.P. Morgan plans to add a couple of financial sponsor bankers in Asia over the next several months, says global co-head George Foussianes in New York. Goldman, meanwhile, is expanding in Hong Kong as well as Japan, according to Berlinski. And Morgan Stanley is beefing up in both Australia and Japan, Bradley says. Citi, too, has been betting on the region. "We've expanded in Asia over the last several years," says Coleman, while keeping "senior head count relative flat in North America and Europe even as the market grew dramatically." That's not surprising, given that Asia-Pacific, excluding Japan, was the only region to see an increase in buyout volume in the first quarter, rising 15%, to $5.8 billion, according to Dealogic. India, Australia and South Korea were the most targeted countries, it says. Sovereign wealth funds, whose cash infusions have helped keep many Wall Street firms afloat amid the credit crisis, could be turning into an important source of fees for the sponsor groups. Last fall, J.P. Morgan added a banker in London to more closely cover sovereign wealth funds in the Middle East, says global co-head Karen Simon in London. The firm is credited with brokering Dubai International Capital LLC's October acquisition of a 9.9% stake in Och-Ziff Capital Management Group LLC for about $1.1 billion before the hedge fund went public. For Morgan Stanley, "far and away, the largest activity is in the Middle East," says Bradley, adding that the firm is also expanding its team there. The sponsor group works closely with sovereigns across sectors and geographies much in the same way it does for buyout firms. "The intellectual capital is similar," he adds. Goldman and Citi are also spending more time with the sovereign wealth funds in Asia and the Middle East. "We're showing ideas to sovereigns on a proactive basis," says Berlinski. Their investment model is becoming more "private equity-like," says Coleman, as they look to make control investments. Citi's sponsor group advised Istithmar PJSC on its purchase of department store operator Barneys New York Inc. from Jones Apparel Group Inc. for $942 million in September; it also advised Citigroup on Abu Dhabi Investment Authority's $7.5 billion investment in the bank late last year. In light of the times, some buyout firms have changed their colors a bit, putting their money to work in distressed credit opportunities. They are investing in bridge and leveraged loans as well as high-yield debt in hopes of generating equity-like returns. Lately, "we're spending more time with clients who are in the credit space," says Citi's Coleman, citing Apollo Management LP, Cerberus Capital Management LP and Centerbridge Capital Partners LP. This has helped Wall Street. Citi has reportedly agreed to sell some $12 billion in leveraged buyout loans and bonds to Apollo, Blackstone Group LP and TPG at an average price of less than 85 cents on the dollar. And Deutsche Bank has held talks with Apollo and Blackstone about selling them just under $5 billion of debt at a slightly smaller discount. Morgan Stanley's Bradley notes that after getting a "huge amount of inquiries," it, too, has sold down a lot of its overhang. But even as banks clear their balance sheets, for megabuyouts to return "you would need the CLO market to come back with a vengeance," says UBS' Smith, noting collateralized loan obligations once made up as much as 60% to 70% of leveraged financing. Generally, bankers see LBOs staging a comeback as early as the third quarter of this year and as late as the first quarter of 2009. "If things stay as stable as they have been," says Mark Epley, global head of Deutsche's financial sponsor group, "we're rocking post-Labor Day." CLOs, though, or a replacement debt product, will take longer to return, possibly next year, he says. Sponsor bankers are also looking forward to a possible wave of large initial public offerings by PE firms next year. Buyout shops picked up many household names during the boom, such asDunkin' Brands Inc., and hired heavyweight talent to run them. For instance, General Electric Co. star executive David Calhoun was recruited to head Nielsen Co., the Dutch media business formerly known as VNU Group BV that was the target of an €8.7 billion ($13.5 billion) buyout in 2006. At some point, those investments will become ripe for exits, including IPOs. "We're going to a see a tsunami of massive IPOs come out next year," Epley predicts. "In retail alone, there's $50 billion of sponsor equity that has to come out." The IPO market is already beginning to show signs of life, Coleman points out, noting that Citi and Credit Suisse last month priced the public offering for Apollo-backed Verso Paper Corp. The deal priced below expectations, however, and its shares fell 16.75% on May 15, their first day of trading. In the meantime, private equity firms are spending more time examining their portfolio companies, which for the most part have withstood the economic downturn. At this point, "we'd call the market stressed, not yet distressed," says Coleman, adding that it's just beginning to see bankruptcies such as Linens 'n Things Inc., a portfolio company of Apollo Management that filed in early May. "Everyone is muddling through," says Smith, who also heads UBS' restructuring group. Problems have been avoided in part because portfolio companies typically have good credit structures and solid cash flow. They might be tagged as highly levered, says Mass, but "they are well equitized compared to eight years ago." Sponsors typically put down 35% equity, she adds. Many have benign bank agreements that are covenant-lite or -free, giving them wiggle room to avoid default. The lull in dealflow hasn't kept Wall Street's financial sponsors bankers -- who are aware that a ton of capital awaits on the sidelines -- from keeping busy. "We're spending a lot of time being creative," says Epley. UBS, for instance, recently provided financing through a whole-business securitization facility to back Aurora Capital Group's $487 million acquisition of Stuart, Fla.-based NuCO2 Inc. It could be the first time an entire buyout has been funded by the securitization market. While times have been tough, the overwhelming consensus is that ties between sponsors and lenders over the long term will remain very strong. They have to. "It's a symbiotic relationship," says Bradley, and a return to a normal operating environment is all but certain. As Bradley puts it, "Every marriage has its good days and bad." -- Christine IdzelisCategories Deal Video
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