Introduction

On 16 May 2017, the European Central Bank (ECB) published its final Guidance on Leveraged Transactions to address the increased credit default risk for banks financing highly leveraged borrowers. The ECB aims to address the risks which became visible following a market review of leveraged finance transactions. The results of that review showed that leveraged debt markets have experienced a strong recovery since the start of the financial crisis. The review also highlighted that fierce competition, both between banks and between banks and alternative capital providers, has led to a very borrower-friendly market which is demonstrated by increased leverage levels and covenant-lite structures. Furthermore, the ECB identified room for improvement in banks’ internal monitoring practices as well as significant discrepancies in how individual banks define and manage leveraged transactions. 

Legal Effect & Scope

Application & (Non-)Binding Effect 

The ECB explicitly states that the guidance, which will be applied from 16 November 2017 on, only serves as an interpretation aid and is not directly legally binding on credit institutions. Nevertheless, the ECB will very likely consider any non-compliance with the leveraged guidance as a violation of the relevant legal binding national legislation which is interpreted through the guidance. Therefore in order to avoid ECB measures, banks are likely to comply with the guidance making it for practical purposes factually binding upon banks.

Addresses

The guidance is directly applicable to “all significant credit institutions supervised by the ECB” under the Single Supervisory Mechanism (SSM) Regulation. Pursuant to para. 4 of Article 6 SSM Regulation, a credit institution is considered ‘significant’ if the total value of a credit institution’s assets exceeds €30 billion or if the ratio of a credit institution’s total assets over the GDP of the Member State of its establishment exceeds 20 per cent.

With regard to less significant credit institutions the ECB is entitled to issue legal acts such as regulations, guidelines and general instructions, which are addressed to the national supervisory authorities in order to unify supervisory practices. It is likely that any such legal acts would mirror the ECB’s expectations for leveraged transactions as summarised in the guidance. In this manner, the leveraged guidance could therefore also impact less significant credit institutions, despite not being directly applicable to them. However, debt funds are generally not addressed by this leveraged guidance. 

Definition of Leveraged Transactions

The guidance is applicable to all leveraged transaction. This term has been specifically defined by the ECB. The ECB’s definition contains – beside various exemptions - two alternative inclusion criteria:

(1) the requisite leverage ratio has been met; or

(2) a financial sponsor is involved in the transaction.

Requisite Leverage Ratio

Any loan or credit exposure where the borrower’s post-financing level of leverage exceeds a total debt to EBITDA ratio of four times should be considered a leveraged transaction.

Regarding the term “EBITDA” under the guidance the subsequent aspects are to be considered:

  • the guidance refers to adjusted EBITDA;
  • such adjustments must be duly justified and reviewed by an independent function; and
  • under certain circumstances the ECB will look at the issue of adjustments, in particular with respect to pro forma ‘future synergies’, ‘future earnings’ or ‘run-rate EBITDA’. 

​The term “total debt” within the meaning of the guidance: 

  • includes subordinated debt such as shareholder loans or payment-in-kind (PIK) instruments;
  • includes any bond debt, regardless of the fact that bond transactions are not considered as leverage transactions;
  • excludes committed undrawn facilities which are referred to as “liquidity facilities” by the Basel III

Furthermore ‘total debt’ refers to:

  • gross total debt by stating that cash should not be netted against debt;
  • to committed debt (including drawn and undrawn debt); and
  • any additional (not yet committed) debt that a loan agreement may permit (presumably this will include additional debt permitted under a loan agreement such as (uncommitted) incremental or accordion facilities – even if they are never used – and any other debt permitted to be incurred outside of the loan agreement). 

Total debt and EBITDA should, in general, be calculated on a group consolidated basis.

Sponsor Test 

The alternative way in which a transaction is brought within the ambit of the definition is if the borrower—at the time the credit is granted—is owned by one or more financial sponsors. According to the guidance, a financial sponsor is deemed to be the owner if it controls or owns more than 50 per cent of the borrower’s equity. As the guidance explicitly states that it is also applicable if the borrower is owned by more than one financial sponsor, it suffices if several sponsors own or control more than 50 per cent of the borrower’s equity. Although not explicitly mentioned in the guidance, it can be assumed that reference to several sponsors ‘controlling’ the borrower’s equity refers to such sponsors acting in concert. Otherwise, this criterion could already be satisfied by financial sponsors holding in aggregate more than half of the shares in the borrower without acting together.

According to the ECB, a ‘financial sponsor’ is any investment firm that undertakes private equity investments in and/or leveraged buyouts of companies, with the intention of exiting those investments on a medium-term basis. The ECB intends to capture leveraged buyouts as well as dividend recapitalisation, share buy-backs and repayment of subordinated debt. In particular, the definition of “financial sponsor” appears to capture private equity funds which, in practice, own a large number of borrowers. Therefore, corporate loans are caught by the ECB guidance regardless of the borrowers EBITDA.

Exemptions 

The guidance lists several exclusion criteria in which the guidance is not applicable, including:

  • Bonds;
  • Loans classified as specialised lending as defined in para 8 art. 147 of the CRR which are characterised by the fact that the primary source of repayment of the obligation is the income generated by the assets being financed;
  • Loans to natural persons, credit institutions, investment firms, SMEs, public and financial sector entities and IG borrowers (BBB-(S&P)/BBB-(Fitch)/Baa3(Moody’s) or above) as well as trade finance;
  • Loans resulting in a credit institution’s consolidated exposure of less than €5 million.

Material Requirements Following From The Guidance

If one of the inclusion criteria is met and no exclusion criteria applies the ECB guidance sets out key expectations in the following four areas:

Risk Management and Internal Framework

  • The senior management should, at least on an annual basis, be defining, reviewing and endorsing the maximum leveraged ratio as well as other limits allocated to leveraged transactions (exemptions are permitted if they are “duly justified”);
  • Transactions where the leverage ratio (total debt to EBITDA) exceeds a multiple of six at deal inception should only be syndicated by credit institutions in exceptional circumstances when it can be “duly justified”. All transactions exceeding this six times ratio should form part of the credit delegation and risk management escalation framework of the credit institution;
  • A specific stress-testing framework for leveraged transactions shall be established; and
  • Banks should define internal criteria to identify indicators of unlikeliness to pay (UTP). They should also ensure that their internal criteria for non-performing exposures, default and impairment classification are fully aligned with, inter alia, legal requirements, the ECB guidance on non-performing loans and the specificities of leveraged transactions.

Governance Structure

Alongside robust internal frameworks, the ECB guidance also embeds the expectation that credit institutions have sound internal governance structures in place regarding leveraged transactions. The guidance specifies three minimum requirements: 

  • First, the senior management and risk management teams shall be provided with a periodical overview containing information about all of the bank’s leveraged transactions, its positioning with regard to its internal limits, the outcome of the afore mentioned stress test, about potential concentrations (in terms of facility type, geography, sector or individual names), the quality and profitability of its leveraged transactions and finally a report containing a section in relation to weak covenant protection and potential material breaches of covenants;
  • Second, an independent risk function should review and approve leveraged transactions (including syndicated and bilateral loans, ‘best efforts’, club and underwritten deals) implying credit, underwriting or settlement risks; and
  • Third, banks are expected to prevent conflicts of interest and breaches of confidentiality which could arise as a result of a single unit being dually responsible for the origination of a loan, as well as carrying out the trading functions

Credit Approval Process

A credit approval process for leveraged transactions, which is meant to work alongside the bank’s internal framework has to ensure that all leveraged transactions are in-line with the framework’s provisions on risk appetite and be conducted by an independent risk function. This approval process should be conducted not only when a new leveraged transaction is being considered but also for the renewal, refinancing and material modification of an existing leveraged transaction.

Ongoing Monitoring 

Leveraged transactions should not only be assessed in the course of the credit approval process but should also be subject to ongoing monitoring, for example, by updating the due diligence carried out prior to credit approval. ‘Hold book’ exposures should be reviewed at least annually, whereas highly-leveraged, non-performing and other deteriorated exposures should be assessed more frequently.

Leveraged transactions should not only be assessed in the course of the credit approval process but should also be subject to ongoing monitoring, for example, by updating the due diligence carried out prior to credit approval. ‘Hold book’ exposures should be reviewed at least annually, whereas highly-leveraged, non-performing and other deteriorated exposures should be assessed more frequently.

Possible Impact 

  • The general view in the market is that the guidance will create a more level playing field between the US and European leveraged market. In line with the impact of the US guidelines, it is likely that the guidance could push down leveraged levels.
  • To the extent that the guidance reduces the flexibility of EU credit intuitions to extend loans to more levered borrowers, this may open the leveraged market to non-regulated lenders (i.e. ACPs/debit funds).
  • Although the guidance is non-binding, it is expected that widespread adoption by EU credit institutions is likely to result in the guidance becoming de facto binding – particularly given the ECB’s extensive powers to monitor and regulate compliance.
  • It remains to be seen what the impact will be for banks not subject to the SSM Regulation (i.e. UK and other non-Eurozone banks). Will such credit institutions be required to indirectly comply with the guidance (i.e. if Eurozone banks are party to the same syndicated deal as non-Eurozone banks or where a non-Eurozone bank conducts business through a branch located in the Eurozone) or will it give such credit institutions a competitive edge?