Leveraged financing is clearly enjoying a renaissance. Silver Lake Partners’ recent $24 billion take-private bid for Dell computers reportedly involves a $15 billion debt package, underscoring how liquid US debt markets are at present.
“Across the marketplace, you’re seeing increased availability of leverage,” a senior North American banker recently told Private Debt Investor. “That’s driven by the cost of leverage and a search for yield across the capital structure. If the Fed is lending at 25bps, and your institutions are lending at three, you can go from there.”
This isn’t exactly a new development, however. Banks, particularly in the US, have been loosening their purse strings again over the past few years, with fund managers increasingly able to obtain favourable rates as well as so-called ‘covenant-lite’ loans. There was some $73 billion in cov-lite loans issued last year globally – accounting for 39 percent of all leveraged loan issuance, according to Standard & Poor’s (see chart). And issuances continue to come thick and fast in 2013.
Covenant-lite loans are controversial because they do not have maintenance tests, which give lenders more control and involve regular reviews of operating performance and are not triggered by a borrower action. Cov-lite loans instead give borrowers more control, as they rely on incurrence tests used to examine the operating performance of borrowers relative to a predetermined “trigger” level, after the borrower has taken a certain action such as debt issuance, dividends, share repurchases, M&A or divestiture. In the absence of one of these actions the company’s operating performance does not trigger a default.
The increased availability of credit has also led to growing debt ratios on corporate deals in the US; leverage levels spiked from “an average multiple of 4.9 times EBITDA …to 5.7 times between the second and third quarters of ”, according to a Bain & Co report.
Higher multiples, combined with the willingness of banks to issue cov-lite loans, could be good news for fund managers seeking to (diligently) refinance or realize assets from pre-crisis vehicles, as well as agree LBO financing for new deals.
But for regulators, it’s been raising red flags.
“Regulators want to do whatever they can to prevent the type of aggressive lending that was common during the boom period,” says one New York-based M&A lawyer.
The Federal Reserve, alongside its sister banking regulation agencies the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), already had guidelines on leveraged loans. While not officially laws that banks are bound to follow, the guidelines outline what regulators consider safe leveraged lending activities, including underwriting standards and how banks monitor the financial health of borrowers.
However the guidelines, originally issued back in 2001, were perceived by the market as “vague and only sporadically enforced”, according to a client memo from Orrick, Herrington & Sutcliffe.
And with leveraged finance markets rebounding, and the appetite for risk growing, regulators felt the need to update their rules, according to numerous market insiders.
In late March the Fed, FDIC and OCC released a revised version of their guidelines. The agencies justified their timing by saying in a joint statement that “while there was a pull-back in leveraged lending during the crisis, volumes have since increased while prudent underwriting has deteriorated”.
So what exactly do the updated guidelines say? A lender’s underwriting standards should be “clear, written and measurable”, the agencies write. To that end banks need to consider “a borrower’s capacity to repay and ability to de-lever to a sustainable level over a reasonable period”. The guidelines go on to suggest as a rule of thumb whether a borrower’s base case cash flow projections show the ability to “fully amortize senior secured debt or repay a significant portion of total debt over the medium term”.
Jason Mulvihill, general counsel for the Private Equity Growth Capital Council, calls that language a significant improvement over regulators’ original proposals for revised rules, which relied on specific percentages as a target for a set period of years. The scrapped language originally included a so-called ‘bright line’ test – a clear, simple rule designed to eliminate ambiguity – requiring banks to measure a company’s ability to fully amortize senior secured debt or repay 50 percent of the total debt exposure over a five-to-seven year period.
“There was a sense that it would be helpful for regulators to be more flexible and reasonable on these details to help the guidelines work better,” Mulvihill said. “By doing so lenders are encouraged to look to a variety of factors, including industry norms, that may affect a borrower’s ability to repay its obligations.”
The agencies’ guidance on underwriting standards, however, preserves what some critics have referred to as another bright line test seen in the original proposals: that a leverage level after planned asset sales (that is, the amount of debt that must be serviced from operating cash flow) in excess of 6x total debt/EBITDA “raises concerns for most industries”.
The guidelines also preserve what the buyout industry argued during a consultation period represented another bright line test: transactions in which the borrower’s total debt-to-EBITDA ratio exceeds 4x or its senior debt-to-EBITDA exceeds 3x will likely be considered leveraged loans.
Mulvihill says relying on any pre-defined debt/EBITDA ratio does not reflect variations in borrower risk profiles that are influenced by a host of variables, but commends the final guidelines for clarifying that its ratios were “examples of criteria and that institutions can define leveraged lending themselves”.
The agencies also said lenders should regularly evaluate the credit worthiness of a private equity firm as to whether it can be relied on as a secondary source of repayment for a portfolio company’s loan.
Measuring the impact
Banks that fail to comply with the guidelines are not necessarily breaking any laws, but open themselves (and the private equity sponsor) to scrutiny from regulators.
“In the end, there are a number of formal steps and actions that could be taken, but it starts with informal guidance and conversations between the examiners and the firm itself to correct the problem,” says one source familiar with the government’s examination process of lenders.
However if that doesn’t work, there are a number of other steps the Fed could take (including issuing a formal enforcement action), which are detailed in Section 5040 of the Federal Reserve Examination Manual. Accordingly, banks “generally take the guidelines very seriously”, says the New York-based M&A lawyer.
So, with the guidelines taking effect this month, should the buyout industry prepare for bankers to become more conservative and once again move away from cov-lite agreements? There appear to be some mixed views, but multiple sources agreed it was too soon to tell.
Today’s cov-lite agreements are also a different animal from the ones signed prior to the credit crisis. Typically they feature a minimum interest cover ratio and a maximum leverage ratio today, whereas in the past they contained no financial maintenance covenants.
Still, with regulators looking over their shoulders, it wouldn’t be surprising to see banks push for more lender-friendly covenants, such as a maximum leverage ratio, says the M&A lawyer.
Others say if the guidelines put a stop to the favourable rates and rights, the private equity industry may simply increase its (already growing) reliance on non-traditional lenders to finance LBOs. Ted Koenig, president and chief executive of Chicago-based Monroe Capital, a mid-market lender, says large-cap senior secured floating rate debt funds and traditional high yield debt funds fall outside of the guidelines’ scope, and thus are not constrained by regulatory concerns that a traditional bank would be subject to.
The impact of the guidelines will ultimately rest on how well financial institutions self-police themselves on underwriting standards. Otherwise, if they raise red flags with the regulators, the so-called credit renaissance may turn into a period reformation