The credit crunch has changed the buyout dynamic for private equity firms. Once able to secure flexible lending terms from investment banks to finance leveraged buyouts, private equity firms have shifted to employing lower leverage and targeting smaller conservative investments.

The shift is largely a function of investment banks desire not to syndicate leveraged loans because of unfavorable credit market conditions. Investment banks currently hold over $200 billion of leveraged loans that they are unable to sell. In addition, investment banks have been somewhat unreliable in guarantying financing and rates, demonstrated by problematic deals such as Sallie Mae.

Although private equity firms face difficulties in financing leveraged buyouts through investment banks, these buyout shops have recently raised record funds. A disconnect exists with the inability to arrange financing and the desire to deploy large amounts of capital. Because of this disconnect, private equity firms, such as Blackstone Group LP, have stated plans to bypass investment banks and directly find lenders for leveraged loans. Bypassing investment banks would result in significantly lower revenues for investment banks. Dealogic estimates investment banks earned $34.2 billion in revenue in the past three years from private equity business. However, direct syndication will only occur in a limited context because completely bypassing investment banks is problematic for private equity firms.

Investment banks provide valuable syndication experience and industry relationships. Private equity firms would need to make dramatic infrastructure and personnel investments to create a similar quality syndication process. Investment banks have longstanding relationships with key asset management firms, endowments, pension funds, and other investors that allow the investment banks to quickly syndicate debt and other financing. Under pricing offerings and other tactics bolster these relationships by providing investors with strong returns.

While private equity firms could reduce expenses through direct syndication, this may also reduce returns of the firms that would purchase the leveraged loans, limiting potential demand for internally syndicated loans. Rapid syndication facilitated by the investment banks’ industry relationships also adds value, especially in the current volatile leveraged loan market. In addition, investment bankers have specific expertise in industries, financial products, pricing, and syndication techniques. This experience would be difficult for private equity firms to replicate without significant investment in internal infrastructure and human capital. This investment would detract from private equity firms’ core business.

Direct syndication also increases risk for private equity firms. Instead of investment banks holding leverage loans on their balance sheets, private equity firms would be forced to hold these loans, concentrating risk. Although leveraged loans should theoretically be quickly sold to external investors, the credit crunch demonstrates that external demand may not always exist. Thus the risk of having to hold large amounts of leveraged loans which would reduce the amount of capital private equity firms could use for other buyouts is a key drawback of circumventing investment banks.

Bypassing investment banks is especially problematic for large debt financing. The ability of private equity firms to circumvent investment banks for smaller deals is less problematic. For example, Hellman & Friedman’s $1.8 billion leveraged buyout of Goodman Global was funded primarily by large direct debt placements with a small group of hedge funds. However, directly syndicating large amounts of leveraged loans would be much more difficult. The $27.4 billion leveraged buyout of Harrah’s Entertainment, for example, would require a private equity firm to arrange numerous direct investors. This process would be time consuming, expensive, and again reduce focus on the core business. Utilizing the services of an investment bank may be more cost effective when a large amount of financing is required.

Investment banks will continue to play an important role in the syndication of leveraged loans for private equity firms. However, large funds recently raised by private equity firms and hedge funds may cause a growing number of smaller leveraged loans to be directly placed between private equity firms and hedge funds. In addition, investments in financial services firms by private equity firms, such as Texas Pacific Group’s $2 billion investment in Washington Mutual, may allow private equity firms to place internal pressure for better financing terms in this volatile credit market. In the long run, however, investment banks will continue to add value through expertise, risk reduction, and syndication for large deals.

Related Sites:
Leveraged Loans Fall by Record as Bank Losses Deepen
The Private Equity Boom: A Net Loser for Wall Street?
Imagining a World Without Investment Banks
TPG eyes financial deals after Citi, WaMu: sources

Key Lessons from the Paulson & Co. - Third Quarter (3Q) Investor Letter

General Overview of Investment Banks

When to Issue Debt Versus Equity

GSTrUE: Goldman Sachs’s Tradable Unregistered Equity OTC Market

Securities Lending