"A couple of the biggest deals just flat lucked out on interest rates because their valuations looked to be too high at the time and they've proved to be too high," said a high-level executive at a competing investment bank that has been accused of undue caution. Had either deal failed, the financial firms would have survived but both would have taken huge losses.
It is widely whispered on Wall Street that three recent merchant banking deals were seriously overpriced--that is, that the cash flow from the companies involved would not even cover the annual cost of interest on the proposed deals. All three were bailed out, sources say, by luck: Interest rates stayed lower than expected and stock prices kept rising.
The three were the agreement in May by the investment banking firm of Morgan Stanley to fork over $917 million of its money to facilitate a leveraged buyout of Burlington Industries, Merrill Lynch's agreement last year to lend $375 million for the leveraged buyout of Detroit truck and trailer maker Fruehauf and First Boston's participation in the Campeau takeover of Allied.
Although the latter was a success, the jury is still out on the Burlington and Fruehauf deals, because the long-term financing has not yet been completed. Hence, the bridge loans made by the investment firms have not yet been paid off, meaning that the firms' capital is still tied up.
The risks can only worsen, Rohatyn predicts, as the field gets more crowded, as firms squeezed by skyrocketing expenses increase their reliance on fabulous merchant banking profits and as the stock market wanes.
"We've all been spoiled by the market's run-up," said Rohatyn, whose firm, Lazard Freres, has shied away from merchant banking because of troubling questions it raises about capital adequacy and potential conflicts of interest with clients. What happens, he asks, "when the market turns the other way and these firms don't have adequate long-term capital" to cover a sour deal?
A parade of regulators, credit raters, corporate executives and business professors has started demanding answers to the same question.
Concerned that the level of risk had risen unacceptably high, thanks to the merchant banking business, bond raters at Moody's and Standard & Poor's recently undertook separate rating reviews of several firms with merchant banking divisions. In part because of concerns raised during those reviews about the adequacy of capital to cover these multimillion-dollar deals and the controls to oversee such transactions, both raters downgraded slightly their ratings of Merrill Lynch.
Merrill, the nation's largest securities firm, is also widely perceived as the biggest and most aggressive player in merchant banking. "This is more credit risk than these firms have ever taken on before," said Clifford Griep, a senior vice president at Standard & Poor's. "If one of these transactions goes bad, even the biggest of these firms would take a very sizable hit and the possible exposure to insolvency is the primary cause for our concern."
Both the Securities and Exchange Commission and the Federal Reserve Board also have been making inquiries into the adequacy of capital maintained by firms making merchant banking deals, according to several firms that have been approached by the agencies.
At the SEC, no "full-blown study" has been launched, said acting Chief Economist Annette Poulson, but "it is something we are very aware of and are trying to keep tabs on."
The merchant bankers, not surprisingly, consider the criticism to be misguided.
"Let's understand, this is a risk business," said William Mayer, managing director of First Boston. "We get paid to manage risk."
No Merchant Banking at Drexel
And to suggest that the firms would cave in to potential conflicts for a few million dollars, Mayer believes, "is almost an insult to the client; you couldn't possibly get away with taking advantage of people that way."
He and others, in fact, make the argument that corporate clients are better served than ever before because now that their advisers have their own money on the line, their advice carries more weight.
Staley Continental, an Illinois corn-processing and food-service company, takes strong exception to that viewpoint. Last February, Staley sued its former investment banking adviser, Drexel Burnham Lambert, for allegedly trying to pressure Staley into a leveraged buyout that would have added millions of dollars to Drexel's coffers.
When Staley insisted on a different strategy, the lawsuit alleges, Drexel tried to sabotage the resulting stock offering by dumping Staley shares.
Drexel denies the charges and the case is still in its early stages. But it is being watched closely by those troubled by potential for conflict of interest in merchant banking deals.