Now that a credit market freeze has crashed private equity firms' dealmaking party, Bear StearnsandLehman Brotherscould be the investment banks left with the biggest hangovers.
Large commercial banks such as Citigroupare on the hook for loads of leveraged buyout debt they hoped to sell to investors, but with a $230 billion market capitalization, Citi is seen as having the balance sheet to absorb any losses without much of a headache.
Large commercial banks like Citi and JPMorgan Chasealso benefit from more diversified businesses including revenue from consumer banking and broad international operations.
With market caps of $14 billion and $33 billion, respectively, brokers Bear Stearns and Lehman are a fraction of the size of their rivals and yet are exposed to several large leveraged buyouts that are struggling to find willing debt investors.
Bear is involved in financing the $26 billion leveraged buyout deal for Hilton Hotelsand the $7.4 billion LBO of Chrysler. Lehman is financing three of the top five announced LBOs this year, which, like Hilton and Chrysler, have yet to be fully funded: the $31.8 billion buyout of TXU, the $22.2 billion deal for Archstone-Smith Trustand the $26.4 billion purchase of First Data.
According to calculations by a brokerage that declined to be identified, assuming an even split among lenders on announced deals and a conservative 40 percent equity, 60 percent debt ratio, Lehman could be on the hook for as much as $22 billion, while Bear could be exposed to $7.9 billion of debt.
That's based on an analysis of announced deals. Actual debt funding commitments are difficult to determine, as banks typically do not disclose their exact exposure until later, if at all. Both banks declined to comment.
If the debt from the deals gets stuck on those banks' balance sheets over a protracted period, that could limit their ability to finance other deals, as well as crimping other activities like trading.
Bear Stearns is the investment bank most exposed to private equity activity, according to an Alliance Bernstein research note, with about 5.1 percent of total revenue coming from LBO firms, known on Wall Street as financial sponsors.
Lehman Brothers is second in terms of exposure at 4 percent, with Goldman Sachs and Morgan Stanley behind them at 3.7 percent each, Alliance Bernstein analyst Brad Hintz said in the July 30 note.
"And of course the issue with financial sponsor activity is the Street in recent years has been making a lot of financing
commitments," Hintz writes. "They've used their balance sheet much more aggressively than what they've done in the past."
Put a different way, Bear Stearns' financial sponsor activity is 51 percent of its M&A deals so far this year, according to Keefe, Bruyette & Woods Inc. Goldman's private equity M&A percentage is second, according to KBW, at 34 percent with Lehman third at 32 percent.
"The postponement and reconfiguration of terms to try and get deals done is worrisome," said Keefe, Bruyette & Woods analyst Lauren Smith, in an e-mail message to Reuters. "The exposures are clearly meaningful for the brokers and many of the large commercial banks looking at the percentages and how they have grown relative to total activity over the past few years."
Both Smith and Hintz rate shares of Bear Stearns and Lehman "market perform" with price targets above where the stocks are trading. The two analysts cite the flurry of M&A activity throughout the year for their ratings.
Bringing in financial sponsor clients has proven to be a lucrative business for banks during the unprecedented boom in private equity activity. Year-to-date, Lehman is ranked 6th in terms of private equity revenues, hauling in $621.6 million in LBO-related fees, according to Dealogic. Lehman ranks ahead of UBS AG and behind Deutsche Bank AG in the rankings, two banks much larger than Lehman.
"They're all at risk, and it's a concern, but relative to the selloff, it may be an overblown concern," said Erin Archer, an analyst at Thrivent Financial. "These situations are ongoing, but my belief is, there is more irrational fear than fear based on tangible data."
Still, the credit markets are shut and the jury is still out on whether the more than $200 billion of leveraged buyout debt held by lenders will find a home.
Bear and Lehman, given their size, look especially vulnerable should the credit markets get any worse.
"I'm less concerned about (LBO) funding commitments with a JPMorgan or a Citi than with the brokers, because the brokers did not build their business models around warehousing credit risk, unlike banks," said Adam Compton, co-head of global financials research at RCM Global Investors in San Francisco. RCM Global has about $150 billion of assets under management.