From November 2017, significant credit institutions in the Eurozone that are supervised by the European Central Bank (ECB) will be subject to the ECB’s recently finalized guidance on leveraged transactions.1 Most “significant” credit institutions are large deposit-accepting banks. The guidance does not apply to other lenders, such as credit funds and investment banks that do not accept deposits.
Transactions to which the ECB’s guidance applies include loans and credit exposures if:
- fifty percent or more of the borrower’s equity is owned by one or more financial sponsors, regardless of the borrower’s leverage level; or
- the borrower has a post-financing Total Debt to EBITDA ratio over 4.0x.
Loans and credit exposures include term loans, bridge loans and revolving credit facilities, but not bonds. Various categories of financing are excepted from the guidance, including limited-recourse asset-based loans, trade finance and financings for small and medium-sized enterprises (except where at least 50 percent of the borrower’s equity is owned by one or more financial sponsors) and investment-grade borrowers.
The ECB’s guidance requires credit institutions to work through a risk framework when originating, modifying, syndicating or refinancing leveraged transactions. The requirements for the risk framework include:
- treating syndications involving high levels of leverage as “exceptional” and any such exceptions “duly justified” (the guidance also states that supervisory expectations relating to the risk management of transactions that present high levels of leverage also apply to “club deals” and bilateral loan structures);
- assessing the borrower’s ability to repay senior secured debt fully or to repay at least 50 percent of Total Debt over five to seven years; and
- treating a syndication as “failed” and subject to a hung deal framework if not syndicated within 90 days of commitment.
The ECB defines high levels of leverage to be a Total Debt to EBITDA ratio at inception of the transaction over 6.0x. The ECB states that this is not a bright-line test in evaluating the risk of a leveraged transaction.
The guidance defines “Total Debt” as total committed debt (including drawn and undrawn debt) and any additional debt that loan agreements may permit. There is uncertainty on whether additional debt refers to further debt actually incurred under the loan agreement, such as an incremental facility, or debt the loan agreement allows the borrower to incur generally, such as under a permitted debt basket. Also, the ECB has stated that subordinated shareholder debt should be included in Total Debt, even though such debt is generally considered tantamount to equity.
The ECB’s guidance is generally consistent with guidance released by U.S. regulators in 2013, but the U.S. guidance is more flexible in certain respects. Moreover, there have been recent indications that the U.S. guidance may be revised.
After the U.S. guidance was finalised in 2013, overall leveraged lending in the United States fell and the market share of non-banks, which were not subject to the U.S. guidance, grew while the market share of large banks declined. A similar effect may occur in Europe if the ECB’s guidance causes credit institutions to take conservative positions with financial sponsors. Other possible consequences include credit institutions being more conservative about incremental facilities, debt baskets and flex rights. There may also be efforts to make more use of financial instruments or borrowers that do not implicate the ECB’s guidance.
In May 2017, the ECB finalized guidance on leveraged transactions following a public consultation on draft guidance released in November 2016. The guidance reflects the ECB’s concerns about credit institutions’ exposure to risks from leveraged finance transactions in light of the prolonged low-interest rate environment, the ensuing search for yield and the competition among credit institutions, which, according to the ECB, has led to weakened deal structures and greater leniency in many credit institutions’ credit policies. In the guidance, the ECB seeks (i) to facilitate the identification of leveraged transactions so credit institutions can have a comprehensive overview of their leveraged lending activities and (ii) to set expectations for risk management and reporting for leveraged transactions to improve credit institutions’ risk management practices.
The ECB’s guidance is to be adopted into the internal policies of credit institutions. The guidance becomes effective in November 2017, meaning affected credit institutions must have such policies in place by then.
The ECB’s guidance follows the Interagency Guidance on Leveraged Lending released by U.S. regulators in March 2013 and a clarifying set of frequently asked questions in November 2014. The ECB intends for its guidance to be broadly consistent with the U.S. guidance and thereby create a level playing field and avoid regulatory arbitrage. But, as we describe below, a recent U.S. Treasury report has proposed reconsideration of the U.S. guidance, which may raise questions for the future direction of the ECB’s guidance.
Affected Credit Institutions
The guidance applies to “significant” credit institutions supervised by the ECB, which are credit institutions established in EU member states that have adopted the euro as their currency, or credit institutions established elsewhere in the European Union with significant branches in member states that have adopted the euro as their currency. “Credit institution” means an undertaking the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account. Whether a credit institution or branch is “significant” is determined by the ECB based on the credit institution’s or the branch’s size, its importance for the European Union or any Eurozone member state and the significance of its cross-border activities. As of April 1, 2017, the ECB’s list of significant credit institutions included 124 institutions.
The ECB’s guidance does not apply to lenders that are not “credit institutions,” such as credit funds and investment banks that do not accept deposits. The guidance also does not apply to credit institutions established outside the Eurozone, such as those based in the United Kingdom (unless they have established a branch in a Eurozone country, in which case the guidance might apply to that branch) or Switzerland. The guidance generally does not apply to U.S. credit institutions, but U.S. banking organizations subject to the U.S. guidance are required to apply the U.S. guidance on an enterprise-wide basis, including to their European operations. (The U.S. guidance also applies to leveraged loans originated or distributed in the United States by non-U.S. credit institutions that have a U.S. charter.)
Definition of Leveraged Transactions
The ECB’s guidance requires each credit institution to develop a single and overarching definition of “leveraged transactions,” which transactions will be subject to its internal policy framework. The guidance requires the criteria for such definition to include:
- all loans and credit exposures where at least 50 percent of the borrower’s equity is owned by one or more financial sponsors, regardless of the borrower’s leverage level; and
- all loans and credit exposures for other borrowers where the borrower’s post-financing Total Debt to EBITDA ratio exceeds 4.0x.
The ECB is targeting any transaction involving a financial sponsor because it views core leveraged transactions as involving leveraged buy-outs (LBOs) and related financing transactions, such as dividend recapitalizations, share buy-backs and repayments of shareholder funding.
Exceptions from the definition include:
- specialized lending, which is limited recourse financing where the primary source of repayment is the income generated by the assets being financed, comprising project finance, real estate finance, object financing and commodities financing;
- trade finance, such as short-term letters of credit for the exchange of goods and services;
- loans to small and medium-sized enterprises (except where at least 50 percent of the borrower’s equity is owned by one or more financial sponsors); and
- loans to investment-grade rated borrowers, which rating may be an internal or external rating.
A credit institution should determine whether a transaction fits within its definition of a leveraged transaction whenever it extends new credit, refinances or modifies an existing loan agreement, renews a matured or maturing transaction, or restructures or changes an existing non-matured loan.
Loans and credit exposures covered by the ECB’s guidance cover the entire debt capital structure of the borrower, including drawn and undrawn facilities, term loans, bridge loans and revolving credit facilities, but excluding bonds (including high-yield bonds) although bridge loans or bridge loan commitments that are intended to be refinanced with a bond issuance would still be subject to the guidance.
The U.S. guidance also requires credit institutions to develop a definition of a “leveraged loan” but the U.S. guidance is less prescriptive than the ECB’s guidance. The U.S. guidance sets out typical characteristics of leveraged loans as a starting point for credit institutions to develop an institution-specific definition. The U.S. guidance does not, however, cover asset-based loans.
Policy Framework for Syndication of Leveraged Transactions
The ECB’s guidance requires credit institutions to have an internal policy framework detailing its risk appetite and governance structure for syndicating leveraged loans, including:
- limits on the quantum and nature of transactions the institution may engage in;
- an independent risk function to review and approve all leveraged transactions;
- acceptable leverage levels as part of the institution’s risk appetite, which may be set by industry if appropriate; and
- policies to deal with “hung deals,” which the guidance defines as transactions that have not syndicated within 90 days of the date the credit institution committed to provide the financing.
The U.S. guidance involves similar requirements, although the U.S. guidance is less prescriptive on governance arrangements.
Acceptable Leverage Levels
In connection with the policies on acceptable leverage levels, the ECB’s guidance states that syndications, club deals or bilateral loans with high levels of leverage should be “exceptional” and any such exceptions “duly justified.” The guidance states that supervisory expectations relating to the risk management of transactions that present high levels of leverage also apply to “club deals” and bilateral loan structures. The ECB’s guidance defines high leverage levels as a Total Debt to EBITDA ratio at deal inception in excess of 6.0x. The ECB states that this is not a bright-line test and that all factors should be taken into account, but that transactions involving excessive leverage raise supervisory concerns for the credit institution, require additional evidence that the institution’s senior management and risk management function is involved, and should be subject to more stringent risk management practices. The U.S. guidance raises similar concerns about high leverage levels and includes a similar, non-bright-line 6.0x test.
“Total Debt” in the ECB’s guidance refers to total committed debt and any additional debt that loan agreements may permit. The ECB considers subordinated shareholder debt and other subordinated debt, such as pay-in-kind instruments, as liabilities and therefore requires them to be included in Total Debt, notwithstanding submissions during the consultation that subordinated shareholder debt has equity-like features. Undrawn liquidity facilities may be excluded. The ECB does not allow cash to be netted against debt. Additional debt permitted under loan facilities includes incremental or accordion facilities, which allow additional facilities under the credit agreement in accordance with pre-agreed parameters without the consent of existing lenders. Credit institutions might also conclude that Total Debt should include other debt permitted under the terms of the loan agreement, such as debt permitted under baskets.
Ratios under the U.S. guidance are also based on gross total debt, which includes additional debt that the loan agreement may permit, but is otherwise less prescriptive than the ECB’s guidance in respect of the debt covered.
The ECB was concerned that aggressive and overly optimistic adjustments to EBITDA in loan documentation and financial covenants, such as pro forma “future synergies,” “future earnings” or “run-rate EBITDA,” may leave investors vulnerable in a downturn. While the ECB’s draft guidance did not allow for such adjustments, the ECB’s final guidance allows EBITDA enhancements if they are reviewed by a function independent of the credit institution’s front office. The ECB left the door open for it to reconsider the issue of EBITDA adjustments in the future. The U.S. guidance allows adjustments to EBITDA.
The ECB’s guidance states that the leverage calculation is to be conducted at the consolidated borrower level unless group support cannot be assumed if the borrower encounters financial difficulty. The ECB suggests that this may occur when there is no formal support, such as a guarantee or letter of comfort.
Credit Approval Requirements
A new leveraged transaction, the renewal or refinancing of an existing leveraged transaction and a material modification to an existing transaction should each trigger a credit institution’s origination unit to undertake in-depth due diligence and its risk function to undertake a critical review. The requirements for the due diligence include:
- an assessment of the borrower’s ability to repay a significant share of its debt or to delever to a sustainable level, which the ECB defines as the ability to amortise senior secured debt fully or repay at least 50 percent of Total Debt over a period of five to seven years;
- an enterprise valuation of the borrower; and
- an assessment of the terms of the transaction, including flagging weak covenant features, such as the absence of covenants or significant headroom in covenants.
The requirement to assess the borrower’s ability to repay its debt originates from the ECB’s observation of liberal repayment schedules in loans, which the ECB states leads to refinancing risk when coupled with a weak ability for the borrower to repay its debt. The assessment of the borrower’s ability to repay its debt need not, however, reflect the contractual repayment schedule of the loan. The assessment is to be made on a base case model reflecting realistic repayment assumptions. In assessing a borrower’s ability to repay its debt, credit institutions should also consider other factors, such as support from guarantors or sponsors, stability of cash flow and the borrower’s ability to restrict dividend payments or reduce expenses without affecting operations.
The U.S. guidance includes broadly similar credit approval requirements, including in respect of the borrower’s ability to repay its debt.
The ECB’s guidance requires credit institutions to monitor their leveraged loan portfolios, including establishing criteria for lenders that are encountering financial difficulties or are unlikely to pay. Credit institutions are to review leveraged loan borrowers at least annually and at other times upon the occurrence of events that indicate a possible deterioration in credit quality. The U.S. guidance requires broadly similar ongoing monitoring.
Implications for Financial Sponsors
The ECB’s guidance is drafted in broad, general terms and leaves considerable interpretation and implementation to credit institutions. Credit institutions may take varying approaches to the guidance and so may raise different concerns based on the guidance when negotiating leveraged transactions with financial sponsors.
Research on the impact of the U.S. guidance suggests that the dollar value and number of new U.S. leveraged loans peaked in the first quarter of 2013, the quarter in which the U.S. guidance was released, and declined thereafter.2 The research also suggests that leveraged lending by large supervised U.S. banks declined after introduction of the U.S. guidance, while leveraged lending by non-banks increased. While other causes are possible, these trends suggest that the U.S. guidance led to greater caution by larger banks in leveraged transactions and that the void was partly filled by unregulated lenders. We have anecdotally seen this trend. A similar trend may follow the introduction of the ECB’s guidance.
Other potential implications for financial sponsors arising from the ECB’s guidance include:
- credit institutions being less willing to include incremental facilities or large permitted debt baskets that result in a high Total Debt to EBITDA ratio because the definition of Total Debt includes other debt permitted under the loan agreement; and
- credit institutions revising syndication flex terms, such as allowing flex earlier in the syndication period, because the guidance requires transactions to be treated as failed syndications - and therefore subject to the policy framework for hung deals - if they are not syndicated within 90 days of a commitment.
Because the ECB’s guidance does not apply to instruments such as asset-based loans and high-yield bonds or transactions by a sponsor’s entities above the borrower, there may be efforts to make more use of such instruments or such entities in transactions. For example, the ECB’s guidance should not generally apply to a refinancing of term loans used to acquire a portfolio company with the proceeds of high-yield bonds issued by the borrower of the term loans. The guidance should also not generally apply to a dividend recapitalization of a portfolio company using the proceeds of pay-in-kind notes issued by a parent of the portfolio company. On the other hand, transaction structures that involve shareholder loans may be more challenging in light of the ECB’s inclusion of shareholder loans in Total Debt. For example, suppose that in an initial LBO financing a tranche of debt was structured as high yield or pay-in-kind notes and moved above the primary borrower and all of the proceeds of those notes were on-lent to the primary borrower by its parent shareholder. In that case, the Total Debt to EBITDA ratio of the primary borrower would not be reduced as compared to all of the debt being incurred in a primary borrower-only structure, even if the on-lending were on a subordinated basis.
More generally, the ECB’s guidance, like the U.S. guidance, reflects regulators’ concerns that competition between credit institutions for leveraged lending has led to aggressive terms and lax lending practices that create risks to financial systems. Points of concern include the absence of financial covenants, weakened covenants as a result of EBITDA enhancements or significant headroom, and excessive leverage levels. Notwithstanding the prospect of more flexibility in the U.S. guidance discussed below, if regulators conclude that the points of concern persist or worsen, they may consider more onerous measures, which could further affect the terms on which credit institutions can provide leveraged lending credit to financial sponsors.
Potential Revision of the U.S. Guidance
In June 2017, less than a month after the ECB finalized its guidance, the U.S. Treasury issued a reportreflecting a view that the U.S. guidance is curtailing leveraged lending by banks and restricting capital available to businesses. The report cites research indicating uncertainty about how the U.S. guidance applies has led to caution by U.S. banks in extending leveraged loans, which has resulted in the migration of leveraged lending to non-banks. The report expresses concern that non-banks often originate leveraged loans using more aggressive and riskier credit structures than allowed by banks. The research also observes an increase in borrowing by non-banks from banks, which suggests that non-banks have partly financed their leveraged lending activities with financing provided by banks and thereby undermined the risk reduction intended by the U.S. guidance.
The U.S. Treasury report cites examples of issues in the U.S. guidance that have led to caution from U.S. banks engaging in leveraged lending. The issues include the 6.0x total debt to EBITDA ratio not being a bright-line test, the ability of each bank to set its own definition of leveraged lending and the lack of clear penalties for non-compliance. The report recommends that the U.S. guidance be reissued for public comment and specifically recommends a “clear but robust” set of metrics for credit institutions to consider when underwriting a leveraged loan instead of the current 6.0x total debt to EBITDA ratio.
While the ECB’s draft guidance was initially more stringent in places than the U.S. guidance, the ECB’s final guidance is, with some exceptions, largely aligned with the current U.S. guidance in order to provide a level playing field between credit institutions covered by the ECB’s guidance and U.S. credit institutions. If the U.S. guidance changes in response to the review proposed by the U.S. Treasury, the ECB will be required to evaluate whether maintaining a level playing field with the revised U.S. guidance will introduce unacceptable risk from leveraged lending to the Eurozone’s financial system.