What is bridge equity?

Bridge equity is money that banks or investors give to a leveraged buyout (LBO) fund or private equity fund. This money helps the fund buy a company. The fund uses bridge equity when it does not have enough of its own money yet to pay for the whole company.

Bridge equity is a special kind of investment. Usually it comes from banks. Sometimes it comes from other big investors. But the key thing is that bridge equity is meant to be short-term. The LBO fund will try to replace the bridge equity with regular equity from other investors pretty quickly, usually within a few months after buying the company.

Why do LBO funds use bridge equity?

LBO funds like bridge equity because it lets them buy companies faster. See, normally when a fund wants to buy a company, it has to first go find investors to put in money for the equity part of the deal. But finding equity investors takes time. And the fund might be worried that while it’s out looking for equity investors, some other buyer will swoop in and buy the company instead!

That’s where bridge equity comes in. With bridge equity, the fund can go ahead and close the deal to buy the company right away. It doesn’t have to wait until it has rounded up the normal equity investors. The banks or whoever are providing the bridge equity will front the equity money for now. Then, over the next few months, the fund can take its time to go find regular equity investors. When it gets that regular equity money, it will use that to pay back the bridge equity.

So in a sense, the bridge equity is like a “bridge” that lets the fund get from the day the deal closes until a few months later when it has the regular equity lined up. That’s why they call it bridge equity.

How does bridge equity work in an LBO deal?

Picture an LBO fund that wants to buy a company for $1 billion. The fund plans to borrow $700 million from banks and put in $300 million of equity. But so far, the fund only has $200 million of equity committed from its usual investors. It could wait to close the deal until it finds another $100 million. But it’s worried the seller might walk away.

Here’s how bridge equity could work in this deal:

1. The fund gets a bank to provide $100 million of bridge equity. Now it has the full $300 million of equity it needs.
2. The fund borrows the $700 million, puts in the $300 million of equity (including the $100 million bridge piece), and buys the company. The deal is closed!
3. Over the next three months, the fund goes and finds more normal equity investors. It raises an additional $100 million from them.
4. The fund takes that new $100 million of regular equity and uses it to pay back the $100 million of bridge equity to the bank. Now the bridge equity is out of the deal and has been replaced by normal equity.

So the bridge equity was in the deal for only a short time, from the closing until a few months later. That’s the typical life cycle for bridge equity.

Who provides bridge equity?

Bridge equity usually comes from big banks. The same banks that are providing the debt financing for the LBO deal will usually offer the bridge equity as well.

Sometimes bridge equity will come from a big institutional investor like a pension fund, endowment, or asset manager. But banks are the most common source.

Whoever provides the bridge equity, they usually charge a hefty fee for it. The LBO fund will have to pay the bank an up-front fee for the bridge equity commitment. Then they’ll pay an expensive interest rate on the equity for as long as it’s outstanding. So bridge equity is costly. But LBO funds are willing to pay up because it helps them close deals quickly.

What happens if the fund can’t replace the bridge equity?

Remember, the plan with bridge equity is always to replace it with regular equity pretty quickly. The banks or other investors who provide the bridge equity don’t want to be long-term equity owners of the company. Their business model is to provide the short-term bridge and then get out.

But what if the LBO fund can’t find enough normal equity investors to pay back the bridge? What if months go by and that bridge equity is still sitting there? This sometimes happens if the company or the economy takes a turn for the worse and investors get scared.

When this happens, the bridge equity provider is now stuck in an uncomfortable position. It has to negotiate with the LBO fund on how to move forward. Usually the bridge equity provider will agree to extend the bridge for a little while longer, but it will jack up the interest rate on the equity quite a bit. It might also start demanding other concessions from the fund. The situation gets tense.

If the fund still can’t find replacement equity, at some point the bridge equity provider may play hardball. It might threaten to take control of the company away from the LBO fund. The legal documents for the bridge equity usually give it the right to do this if the equity is outstanding for too long.

It’s rare for it to reach that point. Usually the LBO fund will figure out some way to get the bridge equity taken out, even if it has to put in more of its own money. But the possibility of the bridge equity provider taking over always lurks in the background. It’s the stick the providers use to make sure the LBO fund is working hard to find replacement equity.