-- Alexander Smith is a Reuters columnist. The opinions expressed are his own --
By Alexander Smith
LONDON, March 26 (Reuters) - Private equity firms are hoping that persuading sellers of assets to lend money to take them off their hands will make up for the lack of bank financing. It may look like an easy win for all concerned, especially at a time when debt capital is thin on the ground. But if these deals sometimes look too good to be true, it's maybe because they are.
Take the proposed sale of iShares by Barclays, where a number of private equity buyers including Goldman Sachs, Bain Capital, Hellman & Friedman, TPG and Vanguard are looking into buying the British bank's exchange-traded funds business. With some putting a price tag of around 4.5 billion pounds ($6.6 billion) on it, getting the funding from banks is now out of the question. But Barclays would like to sell iShares to bolster its capital position and thus avoid signing up to the UK government's asset protection scheme. It is reported to be willing to finance up to 80 percent (or around 3.6 billion pounds) of the price itself.
Lending money to someone to buy an asset off you is not as odd as it sounds. As a seller, with a first-hand knowledge of the assets you are disposing of, you should have a better idea than most of how much they are worth, how they are trading and what their prospects are. In the case of iShares, Barclays ought to have a shrewd idea of value. Moreover, while a clean sale would be better from a capital perspective, Barclays doesn't lose all that much from self-financing the deal. Were the bank to lend 3.6 billion pounds, it could have to reserve as little as 360 million pounds (or roughly 10 percent) against the value of the loan. That would only put a small dent in the 4 billion pound capital gain that Credit Suisse analysts estimate it would make on the deal. And, there's another small dollop of icing on the trade. Barclays would have avoided selling the asset to one of its competitors.
Of course, vendor financing carries risks too. iShares might be badly managed by its new owners. In extremis, the vendor might even have to reassert ownership were the buyers to fail to meet interest payments on the loan. These risks arguably rise the more debt you load onto the deal. At a debt-to-equity ratio of 80 percent, there can be a temptation for a bidder to be reckless as the equity component is sufficiently slender to be akin to an option premium. Moreover, for a vendor in need of capital, as is the case with Barclays, there may be a temptation to inflate the price by offering a wad of debt.
The somewhat incestuous relationship involved in vendor financing can also have disastrous consequences for the buyer. An example of the model gone mad was Spanish property group Metrovacesa which was encouraged to pay over the odds when it bought HSBC's landmark skyscraper in London's Canary Wharf at the top of the commercial property market with the help of an HSBC loan. Metrovacesa's world fell apart when property prices crumbled and it was forced into the hands of its lenders. HSBC was able to buy its European headquarters back for a tidy 250 million pounds less than the 1.1 billion pounds it sold it to Metrovacesa for.
Snapping up iShares with help from Barclays may seem like an attractive proposition. But buyers should beware and, more importantly, shareholders treat the equity released with some caution until the buyer has shown itself capable of repaying the loan it has shouldered.