Bridge Loans in Investment Banking

Investment bankers play different types of roles when it comes to capital raising. Most of the time, they are middlemen who ensure that the requirements of both parties are met and that the deal goes through smoothly. However, often the acquiring party falls short of cash to complete the acquisition. In such cases, it is not uncommon for investment banks to become temporary investors and provide the cash to complete the transaction. This process is called a “bridge loan” and is often used extensively by companies, particularly when they indulge in leveraged buyouts.

In this article, we will have a closer look at what bridge loans are and how they affect the investment banking business.

What is a Bridge Loan?

A bridge loan is a short-term loan which is taken by companies when they make acquisitions. For instance, when a company tries to engage in a merger, it is possible that they may have budgeted for $100 million. However, during the acquisition, the deal may be valued at $115 million. Hence, the company has to either arrange $15 million at a very short term notice or lose the deal. In such scenarios, companies end up taking bridge loans.

As can be seen from the above example, bridge loans are not permanent. Over the longer term, the company arranges a different form of financing, which could be either debt or equity. This loan, which ultimately replaces the bridge loan, is called takeout financing. The cost of bridge loans is significantly higher than the takeout financing. This is because companies do not have too many options while taking bridge loans, and also these loans can be quite risky.

Why are Bridge Loans Considered Risky?

The 2008 crisis provides a cautionary tale of the risks which are involved in bridge loans. Prior to the 2008 crisis, investment banks were funding many high stakes acquisitions with bridge loans.

When the crisis hit, these banks had considerable capital tied up in the form of bridge loans. The problem was that after the crisis, the capital markets almost froze for some time. There was hardly any liquidity at that time since investors were trying to get their money out of the market. Hence, during that time, there was no takeout financing available either in the form of debt or equity.

As a result, investment bankers ended up financing the acquisitions long term. This was particularly painful for investment banks since, at the same time, their own solvency was also in question! During the crisis, the nine biggest investment banks in the world collectively had $250 billion in loans, which weren't being repaid on time.

Why do Investment Banks Give Bridge Loans?

Investment banks benefit in a wide variety of ways when they give out bridge loans. Some of the fees and charges which they earn in the process are as follows:

Investment bankers charge a commitment fee for the bridge loan being made. This fee can be thought of as processing charges for the bridge loan. They depend upon the amount of loan being taken and become due as soon as the loan is originated.

Investment bankers also charge a higher interest rate as compared to the prevailing market rate. This higher interest rate is meant to compensate the bank for the extra risk they are taking by locking their capital in the transaction.

Investment banks also charge a takedown fee for a bridge loan. This can be thought of as pre-closure charges. This fee becomes payable when the company has finally been able to secure long term financing.

Also, investment banks also try to ensure that they have exclusive rights over the securities issue that will be done to pay back the bridge loan. This would mean more business for the underwriting department and a host of other fees that they stand to gain from the floatation costs being incurred.

Hence, a wide variety of fees and costs are paid by companies that are desperate to close the deal. This is what makes bridge financing lucrative for investment banks all over the world.

Bridge Loans and Ethical Issues

Investment bankers all over the world have been making significant money from bridge financing. However, there have also been several questions that have been raised on whether these loans are ethical. These loans have been accused of creating conflicts of interest. Some of the examples are as follows:

Firstly, bridge loans are cash spinners for investment banks. This is why it creates an incentive for investment banks to deliberately create situations in which the acquiring company might need a bridge loan. This is a violation of the ethics code since the best interest of the investment bank is opposed to the best interest of the acquiring company.

Investment banks are often paid advisory fees by companies to help them with mergers and acquisitions. It is likely that their advice will be skewed towards making the acquisition. This is because if the acquisition goes through, they stand to make money in various forms of fees. When advisory and bridge loans are mixed, an inherent conflict of interest is created, which makes the advice biased.

Companies often appoint different investment banks for advisory and bridge loan purposes in order to mitigate these risks. Fees obtained from bridge loan financing continue to be an important source of revenue for the investment banking industry.