Find the controls that extend the bridge!

"Hung bridge" was a term I don't think I had heard before a few days ago, but the concept is easy enough. When a private equity firm wants to do a LBO, they may plan to secure a bank loan, sell bonds or both. If get a bank loan, they can privately talk to the banks about securing the loan before making the LBO public. But obviously they cannot do the same for a public bond offering. Hence at what rate and under what terms they can complete the bond offering is an unknown. Its possible that conditions are such that they cannot get the bond deal done at all, or at least at a rate that makes the economics of the LBO work.

In order to mitigate this risk, private equity firms negotiate a plan B: a bridge loan. Basically this is meant to be a short-term loan that will "bridge" the gap between when the acquisition closes and when the bond issue proceeds are available. This allows the private equity firm flexibility as to when go to market with the bond issue.

Usually a bridge loan is easy money for a bank. Generally they get a commitment fee up front, plus interest, and the loan is usually only outstanding a matter of weeks before permanent financing is in place. Easy money that is until the acquirer can't go to market with the bond. In that case, the acquirer can keep the bridge outstanding for an extended period of time (e.g., up to 10 years in Alltel's case) albeit with various terms and/or rate step ups imposed.

Because bridge loans were seen as easy money by banks, the market to make such loans became very competitive. Not surprisingly, when banks were falling all over themselves to make these loans, they became more and more willing to accept borrower-friendly terms.

Now, they're coming through! The high-yield calendar is flooded with LBO-related offerings. In August alone it is expected that First Data, Clear Channel, Biomet, and ACS will all come to market with multi-billion dollar bond issues. That doesn't even get into Home Depot, Alltel, Chrysler, and Sallie Mae which could well be coming to market soon as well. That has high-yield spreads widening rapidly, and investors starting to demand more stringent covenants. Stringent covenants can be a problem for LBO transactions, since there is often existing debt covenants to deal with as well.

Anyway, so now banks are growing concerned that these bridge loans are going to turn into term financing. Yesterday Jamie Dimon (JP Morgan CEO) said that he expects "semi-dramatic" debt repricing, and also said the firm was marking down its "hung bridges" significantly. How something can be "semi-dramatic" is one question, but that aside, for Dimon to speak so openly about it tells you something. I believe when you hear a public company CEO talk about how bad things are in one line of their business, its often to get people in the mindset that either 1) its far worse than analysts currently think and they need to adjust their estimates, or 2) things are going to keep getting worse, so be prepared for me to keep using this as an excuse for why earnings aren't higher.

The high-yield market is going to suffer because of this supply problem. Remember, even if no bond deal is ever consummated, the bank will likely buy CDS protection, and that will keep the market soft for a while.

My view is that high-yield stabilizes near here, although probably just a bit wider. Once the supply problem is past, the market will remain skittish. Historically, high-yield tends to widen much faster than tighten. Plus the supply problem will not suddenly pass, it will just get lighter sometime after September. Third, many market participants were growing weary of the historically tight levels anyway, and I'll bet they are loathe to jump back in with both feet, even after the recent widening. The Merrill Lynch High Yield Master was as tight as +241 on 6/5, and is now +320. I think there will be plenty of buyers between +350 and +400, but I see it as being a stabilizing point, as opposed to a tightening possibility.

Maybe the high-yield market just needs a little kiss. For luck.