The Dodd-Frank Act’s proposed ban on proprietary trading, known as the Volcker rule, will make it more difficult for banks to provide bridge financing for speculative-grade borrowers.
Companies usually exchange bridge borrowings with notes, which then are distributed to bond investors by the underwriting lenders. The planned ruling will prevent the banks from selling these notes for at least 60 days following the exchange and force them to keep the risk on their balance sheet, according to law firm Paul Hastings LLP.
A consequence of the proposed regulation could increase the cost for borrowers as well as reduce the availability of bridge loans, according to Richard Farley, a New York-based attorney with Paul Hastings. About $63.9 billion of this type of debt, which is used to finance buyout transactions, have been arranged this year, according to data compiled by Bloomberg.
“The whole purpose of this is to make sure that banks aren’t doing risky things and this is totally antithetical to that objective,” Farley said in an interview. “Being in a hung bridge takes on a whole new dynamic of risk because you can’t really dribble out the securities.”
When a bridge loan comes due the company typically issues high-yield notes that its bank underwrites and distributes to investors in separate negotiated transactions, or so-called “dribble-out” sales.
The Volcker proposal prohibits the acquisition of a security if it is “principally for the purpose of a short-term sale,” which would require the underwriter to either hold that risk on its balance sheet or to only make bridge loans when it’s certain there’s enough demand to syndicate the extended notes.
Dodd-Frank, which was enacted in July 2010, bans banks from having more than 3 percent of their Tier 1 capital invested in private-equity and hedge funds. The law requires lenders to deduct aggregate investments in the funds from their Tier 1 capital.
The Volcker rule, named for former Federal Reserve Chairman Paul Volcker, specifically exempts loans from the list of financial instruments that fall under the prohibition, Elliot Ganz, general counsel of the Loan Syndications and Trading Association, said in a telephone interview. However, when banks arrange bonds for borrowers to replace bridge loans, those securities wouldn’t be exempt.
Kinetic Concepts LBO
If the rule were currently being imposed it might have affected the financing of Kinetic Concepts Inc.’s acquisition by Apax Partners Inc., which is the largest leveraged buyout since Lehman Brothers Holdings Inc. failed in 2008.
The San Antonio-based wound-care company had planned to market $750 million of senior unsecured notes to finance a portion of the deal. The borrower so far has sold $1.75 billion in bonds for the transaction.
As the Volcker rule is written, the banks that underwrote that slice of the financing package wouldn’t be able to sell those notes to investors as market demand presented itself, according to Hastings’s Farley. The lenders would have to hold those notes as an investment, which means not intending to resell them for at least 60 days, to be compliant with the proposed rules
“Given Basel III coming down the pike and the capital charges and their reluctance to hold so much inventory on their books,” banks would be reluctant to underwrite more bridge loans, said the LSTA’s Ganz.
Basel III imposes a global regulatory standard on capital adequacy and liquidity of banks. The Basel Committee on Banking Supervision said banks deemed too big to fail must hold as much as 2.5 percentage points in additional capital as part of efforts to prevent another financial crisis, according to a June 25 statement. Additionally, internationally active banks should hold core Tier 1 Capital of 7 percent of their risk-weighted assets.
U.S. regulators requested public comments on the Volcker rule on Oct. 11. The public can comment until Jan. 13. A final version is slated to take effect on July 21, 2012.
“If you’re going to constrain market making, it will constrain issuance,” said Ganz. “And if that happens it will not be good for the bridge-loan market because without a takeout, banks will be very reluctant to put that on their books. There are so many unintended consequences and it looks like this is one of them.”