A common theme in many private debt fund managers’ investment theses is the effect of regulation on bank lending. With higher tier-one capital ratios tempering appetite for risk (at least, relative to the pre-crisis years), banks aren’t lending like they used to.
Meanwhile, private equity sponsors have amassed massive amounts of investment capital. Interest rates remain at record lows, lowering the cost of capital and increasing the pressure felt by sponsors to put that capital to work. Someone has to fill the void for deal financing. Hence, private debt.
But while regulations have certainly influenced banks’ decision making, questions surrounding those regulations continue to persist, making it difficult to gauge just how limited those institutions have become in their underwriting.
Fortunately, the situation may be getting clearer.
First, some background: Citing concern with the declining usage of maintenance covenants and other lender protections, The Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation and The Federal Reserve issued leveraged loan financing guidelines for banks in March 2013.
The guidelines demanded that banks establish internal definitions of leverage lending that would be applicable across business lines, then complement that definition with underwriting standards that would “define acceptable leverage levels and describe amortisation expectations for senior and subordinate debt”. All while establishing a credit limit and concentration framework that is “consistent with the institution's risk appetite”.
Though vague, the guidelines also requested banks’ underwriting standards to consider covenant and leverage protections, noting that leverage levels in excess of 6X total debt/EBITDA are cause for concern for most industries.
Although regulators called for banks to construct internal policies to define their leveraged loan activities, the guidelines themselves do not function as a rule, and as such “you don’t know exactly what the consequences would be” for failing to comply, Alan Avery of Latham & Watkins told Bloomberglast month.
The vague quality of the guidelines has created uncertainty, and regulatory concerns have already forced some banks to avoid certain deals, with The Wall Street Journal reporting that such concerns influenced JP Morgan Chase, Deutsche Bank and Bank of America to sit out recent Carlyle Group acquisitions.
Bloomberg went on to report that the regulators may update those guidelines, providing some much-needed clarification on how banks should negotiate the leveraged finance business in a buyout era characterised by rising prices and elevated debt-to-EBITDA ratios.
When asked about clarified leveraged loan guidelines during a first quarter earnings call earlier this week, Tony James of The Blackstone Group sounded optimistic about the potential impact such an action would have on his firm. “That’ll actually help our business because it’ll restrict some of the bank activity, which will affect what they do with their balance sheets,” James said, adding that the restrictions will allow GSO to step in to provide financing on deals when needed.
Indeed, given the growing role of non-traditional lenders in today’s marketplace – something James has commented on extensively – GSO (and Blackstone’s private equity arm) will almost certainly benefit from a banking sector that possesses a firmer understanding of how or when they can act as underwriters. Clearer guidelines will allow the firm – and others like it with financing to deploy – to gain a better understanding of the banking sector, which in turn improves the competitive landscape.