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Effect of Bank Credit Downgrades on M&A Deals

Fifteen of the largest “too big to fail” banks recently sustained serious downgrades to their credit ratings from one or more credit rating agencies. M&A transactions that require some level of bank financing will be affected to a limited degree, in the future as lenders attempt to regain their formerly more favorable ratings.

These downgrades will impact M&A transactions by limiting the capital available to fund deals. Deal terms also will get tougher as lenders seek to improve their balance sheets and risk profiles. Paradoxically, some commentators expect banks to assume more risk by engaging in derivatives and other forms of proprietary trading to recoup some of the profits lost, because the credit downgrades will cause banks to have to set aside additional capital, increase their reserves and, to a limited extent, pull back from traditional forms of lending.

A bank receiving a credit downgrade is perceived by the markets as being more risky, less solvent and less credit-worthy than prior to the downgrade. To improve its credit profile, a lender can be expected to take certain corrective actions. Some of these actions will directly affect M&A deals.

First, to be less exposed to a catastrophic event, and to attempt regain its higher credit rating, a lender can be expected to increase its capital. If a bank transfers its own funds to capital, there is less money available for loans and for day-to-day operations.

Second, although many people outside of the financial markets are surprised to learn that banks need to borrow money (because their funds are out on loans, required for operational expenses, and more controversially, funds are invested in trading and hedging activities) a credit downgrade makes the cost of borrowing funds more expensive, also leaving the borrowing bank with less money available to fund deals.

Third, deal terms are likely to become more stringent as lenders attempt to lessen their exposure to “deals gone bad.” Buyers and sellers will not only need to have more equity in deals, but air balls, to the extent the markets have been beginning to tolerate them again, also will become constricted.

None of this is to say banks will exit the M&A arena. Good, profitable deals are out there and they will be funded. The negative impacts of a one- or two-step downgrade will be incremental; however, the above actions demonstrate that there will be impacts.

Finally, big banks’ proprietary trading losses have also been in the news lately. It would be highly ironic if lenders attempt to “make up” the lost profits caused by having to divert funds to capital, and by expending more on their borrowing costs, by taking increasing risks in their proprietary trading activities. Deal loan repayments occur over an extended period of time. Trading has the potential to generate large profits quickly. However, we have all seen the results of large scale hedging that morphed into ill-considered, poorly supervised gambles.

Although the effect of a credit downgrade suffered by a large bank on M&A activity may not be immediately obvious, the ripple consequences of the downgrade will impact buyers, sellers and M&A professionals.

If you have any questions this trend, please feel free to contact your Davis & Kuelthau corporate attorney.