As competition for deal-making fees peaked early last year, many banks provided bridge equity in some of their clients’ buy-out targets. That meant taking on extra risk. They were usually able to reduce or eliminate their exposure once the deal closed. But bankers including Jamie Dimon, JPMorgan chairman, still condemned equity bridges as “bad financial policy” and the practice diminished as lenders grew risk averse.
Equity bridges have been common for years, however, in commercial real estate, where a decade-long boom made them lucrative. With pricing now threatening to soften, the equity components of some ambitious property deals are looking tenuous.
Lehman Brothers, with Banc of America Strategic Ventures and Barclays Capital, took on a $4.6bn equity bridge as part of last year’s buy-out of Archstone-Smith with partner Tishman-Speyer. At the pricing assumptions used in the deal, Archstone’s loan-to-value ratio stood at 76 per cent, according to Standard & Poor’s. But if the apartment rental market softens substantially and Archstone’s capitalisation rate – a ratio of operating income to a property’s price – was assumed to be a less aggressive 7 per cent rather than the slightly more than 4 per cent used in the deal, it could feasibly push Archstone’s value below the
sum of its debt, rendering equity worthless. Capitalisation rates on some competitors’ properties have already risen that high, although Archstone’s high-quality buildings have held up well thus far.
Archstone plans to sell one third of its portfolio to fund interest payments and new developments. If prices soften, it may have to sell more properties, repay debt more slowly, or delay new projects on which its growth depends. Lehman and its partners have syndicated out some of their stake, but they still hold some. They may eventually have to revalue it unless they can sell away the risk. That could be tricky – at least at the price they originally paid.