The Loan Arranger Rides Again
What to do about the conflicts of interest prevalent in today’s corporate borrowing.
This year marks the 20th anniversary of the Financial Services Modernization Act (FSMA), also known as the Gramm–Leach–Bliley Act, signed into law in President Clinton’s second term. The goal of this legislation was to improve the efficiency and competitiveness of the financial services industry by removing legal barriers between commercial and investment banking. In reality, it laid the groundwork for an oligopolistic universal banking industry, in which a small number of institutions provide a wide variety of services across the commercial and investment banking spectrum.
Once implemented, the FSMA led to a massive consolidation of financial institutions. Today, according to FDIC data, more than 50 percent of all deposits in the United States reside with the four largest bank holding companies, and these are the same companies that sit atop the league tables in merger and acquisition (M&A) advisory, loans, bonds, and equity offerings.
In 1997, Alan Greenspan, then-chairman of the Federal Reserve, explained the rationale for the FSMA this way: “Many companies and individuals want to deal with a full-service provider that can handle their entire range of financing needs. This preference for ‘one-stop shopping’ is easy to understand. Starting a new financial relationship is costly for companies and individuals and, by extension, for the economy as a whole. It takes considerable time and effort for a customer to convey to an outsider a deep understanding of its financial situation. This process, however, can be short-circuited by allowing the customer to rely on a single organization for deposit services, loans, strategic advice, the underwriting of debt and equity securities, and other financial services.”
Over the past two decades, independent investment banks have grown significantly, suggesting that the predicted benefits of the one-stop shop were overestimated, at least in investment banking. Ken Moelis, founder of the investment bank Moelis & Company, said in a 2013 interview with Fortune: “The aberration isn’t the boutique. The aberration is the belief that it could all be conducted more effectively under one roof. The world developed with advisory and investment banks and commercial banks separate for a reason. It was only a short time ago that everything was put together.”
M&A experts like Moelis have long led the independent banking movement. In 1995, after two years as deputy secretary of the U.S. Treasury Department, Roger Altman founded Evercore, a firm that is now considered the gold standard for independent M&A-focused investment banks. According to Altman, his guiding principle in building the firm was that “clients would be better served by advisors not tethered to the demands of a multiproduct financial institution.”
Independent Advisors Disappear from the Lending Process
Since the adoption of the FSMA, the term “independent investment bank” has typically been synonymous with M&A advisory services. Yet one often-overlooked area that has changed even more fundamentally under the new rules is the very straightforward loan-making function of a bank. FSMA was intended to make financial services easier for clients to navigate, but it also killed the role of the independent loan intermediary, or “arranger”—which, in the end, makes it more challenging for corporate borrowers to ensure they’re getting the best deal and often creates a conflict of interest.
Prior to the enactment of the FSMA, investment banks such as Goldman Sachs or Morgan Stanley often acted as an intermediary between a company seeking to borrow and the banks or other capital providers looking to lend. Utilizing an independent loan arranger gave the borrower an expert advocate who was working solely on its behalf. The loan arranger would identify prospective loans, screen offers, and negotiate with the lenders on behalf of the corporate borrower.
This dynamic creates inherent conflicts of interest, which are abundantly clear in what used to be the sleepy stock and trade of a commercial bank—loan making. For example, acquisitions are commonly financed using loans. These loans are often arranged by a division of the same bank that is providing strategic deal advice through its M&A advisory group. Subsequently, the loans are either held by the bank or syndicated to multiple lenders that may include other banks and institutional investors (hedge funds, mutual funds, private equity funds, etc.). This dual role as both advisor and “arranger” can create a misalignment of incentives.
Such was the case in the 2010 Del Monte Foods merger with a private equity group led by KKR. Del Monte was advised by Barclays Capital, but Barclays also provided the buy-side financing. A shareholder suit was brought, and the Delaware court stated that Barclays had “secretly and selfishly manipulated the sale process.” However, the court also said that Del Monte’s board failed to provide the oversight that would have checked Barclays’ misconduct. Ultimately, Del Monte and Barclays agreed to settle the suit for $89 million, one of the biggest recorded in the Delaware Court of Chancery.
As DealBook reporter Michael J. de la Merced wrote at the time: “At the heart of the dispute was Barclays’ role as an advisor to the seller and a provider of financing to potential buyers. Documents disclosed through the litigation showed that Barclays first began shopping Del Monte Foods as an acquisition target to potential buyers, hoping to reap big fees by lending money to private equity firms for a deal. By working on both sides of the transaction, Barclays stood to essentially double its fees.”
It’s hardly surprising that some corporate boards and finance executives have become increasingly skeptical about relying on the largest universal banks for all their advisory services. When a company is hiring an external advisor for guidance on major financial decisions, shouldn’t the advisor’s interests align clearly with the clients’?
Conceptually, it would seem that corporate borrowers could include in their agreements with loan intermediaries a clause that prevents the arranger from also serving as a lender. In practice, however, this is difficult. It would be a bit like walking into a Ford dealership and saying, “I’d like to buy a new car. I’ll pay you for your time and advice, but what kind of car—that is not a Ford—do you recommend?”
In addition, the universal banks are all highly attuned to the actions of the others, which effectively stifles competition. This is the nature of an oligopolistic industry: When there are few players, each knows what the others are doing. The universal banks are constantly in discussions about rates, covenants, and other issues related to corporate lending. Finance professionals may think that by getting bids from two different banks, they’ve created a competitive dynamic, but in reality, the banks are usually in sync. I like the analogy that universal banks are like aspen trees. When viewed from above ground, they look like individual trees, but when you dig down, you find that their root systems are interconnected. A single universal bank will be only as aggressive (competitive) on terms as it needs to be to attain the position it wants in the syndicate.
Eliminating the role of the dedicated and independent loan arranger puts the borrower and its universal bank advisor at odds on the most basic terms of a loan. Obviously, a decrease in price for the borrower means less revenue for the lending bank, and less-stringent terms for the borrower lead to more risk for the lender.
Regardless of the setting, most people would be justifiably uncomfortable if the agent they hired as an unwavering advocate in any financial transaction also became the principal on the other side of the table. Consider real estate: Because selling a home is such a significant transaction, people generally hire a professional broker, who can leverage market knowledge, buyer networks, and transaction experience to ensure that the seller makes the most lucrative deal possible. If the real estate agent himself ended up purchasing the home, a seller might reasonably be quite concerned the agent hadn’t made every effort to secure the highest possible price. Likewise, when a corporate borrower allows a universal bank to combine the arranger and lender roles, it is essentially selling its loan to the intermediary, and it can expect to pay its financial advisors through their investment choices.
The Alternatives: What a Treasurer Can Do
Understanding the dynamics and risks inherent in the universal banking model is a critical component of risk mitigation for treasurers as they consider the use of loans in their financing strategies. Here are some steps finance professionals can take to increase their odds of achieving the best outcome:
- Begin the process early. The more you need the capital, the less negotiating power you have.
- Be attentive to the motivations and interests of both your advisors and your counterparties in every transaction.
- Understand and evaluate the tradeoffs embedded in each type of loan product. Consider how using each type of product might impact your long-term capital structure strategy and capital allocation decisions.
- Cultivate new commercial and corporate banking relationships with aspirational firms.
- Be willing to refresh your bank group to create true competition. Understand that it is a living, breathing ecosystem which might be healthier if you dropped some misaligned banks and added new alternatives.
- When allocating your credit facility, be careful to avoid concentrating excessive influence on a small number of banks.
- Monitor the bank loan market for comparable transactions to learn of new additions and enhancements. Look outside your industry for deals involving companies similar to yours or transactions with a similar credit profile.
- When needed, seek the advice of an independent loan arranger.
The universal banking model has shifted a great deal of power to the capital providers, especially in the loan capital markets. It is not surprising that the independent loan-advisor role is once again in demand. One could even say the loan arranger rides again, protecting the interests of borrowers in the wild, wild capital markets.