The credit crisis is straining the relationships between banks and their corporate clients, as financial institutions try to preserve capital without withdrawing services to their customers.
The need for banks to retain capital on their balance sheet to meet regulatory requirements and protect against further losses from leveraged loans has led to them taking tough decisions regarding how they will lend.
They can't afford to lend with the same aggression that characterised loans before August 2007. The drought in liquidity means that banks don’t have the funds to lend, and they don't want to take on the risk.
These balance sheet concerns, coupled with historical lows in the secondary market are making banks reluctant to engage in traditional syndication. Instead, there is a greater focus on putting together club deals, where a group of banks team up to share the debt provision for a transaction, as more financial institutions seek to limit their risk exposure.
The resurgence of club deals marks a significant downturn.
The resurgence of club deals marks a significant downturn in the capital markets. Club deals dwindled in 2007 because ample credit options and growing fund sizes meant that buyout firms were able to secure ever larger deals from willing co-investors. In the next six months, the volume of club deals is forecast to be higher than in the whole of 2007.
For private equity clients, there are clear advantages for pursuing a club deal. They increase the private equity firm’s chances of delivering an offer for a company in the face of competing trade buyers. The banks agree terms and conditions from the outset and are credit-approved, creating some certainty. In addition, the club deal removes the uncertainty surrounding the structure, fees and pricing, known as ‘flex’, often associated with transactions underwritten by banks. Private equity clients will therefore know exactly how much a deal will cost them.
Club deals can have their limitations for both sides of the transaction. Private equity firms often need to have the benefits of a club deal, accelerated timing, improved orderliness and reduced frustrations, sold to them.
The number of banks engaged in each club is rising, with a typical transaction having a team of between five and eight banks providing finance. This means deals are becoming more complex and the length of time it takes to close a transaction is increasing.
For banks, the main frustration with club deals is the absence of an underwriting fee. Instead, they usually receive a coordination fee. The role of coordinator, and the prize of a higher fee, is coveted by the banks in the club. Often, the bank with the best track record or the closest relationship to the private equity firm is the winner.
As competitors now become deal companions, banks have to develop closer ties with their counterparts at other club banks.
There can be instances of friction as banks try to elevate their position within the club, aiming to enhance fee income by securing the coordinating role for their bank.
There can be instances of friction as banks try to elevate their position within the club
Interestingly, the competitive tension that clubbing creates between banks is contrary to the concerns raised by regulators in the UK and US that such deals may be anti-competitive. In 2006, the UK regulator, the Financial Services Authority, scrutinised club deals and concluded that they are not anti-competitive.
That was no surprise to the banks which use this style of financing. Private equity firms often get better pricing by taking the club rather than the traditional underwriting route. Companies retain the same power to drive a transaction whichever route is pursued, and ultimately, their shareholders can reject a bid.
The current level of caution and conservatism over lending may not last, and banks may find a middle ground that enables them to finance transactions through the traditional syndication route. But until then, the club route remains the most viable way to meet the needs of private equity clients and maintain deal flow momentum.