The European Central Bank’s (the “ECB”) guidance on leveraged transactions (the “Guidance”) took effect on 16 November 2017. The Guidance comes as a result of the survey undertaken by the ECB in 2015 on the involvement of credit institutions and the extent thereto in leveraged financing transactions. Market recovery and increased competition between lenders has led to an amplified desire for underwriting and, consequently, there has been an increase in borrower-friendly conditions, including financial covenants and leverage levels. Financial institutions’ credit policies have also relaxed, resulting in significant discrepancies between credit institution approaches to defining, measuring, and monitoring leveraged transactions. Each of these factors have led the ECB to improve its guidance and increase its scrutiny on leveraged transactions, focusing on: (i) monitoring syndication risk, (ii) the identification of leveraged transactions’ credit quality, and (iii) setting consistent risk management standards across European credit institutions.
Application of the Guidance
The Guidance applies to all significant credit institutions supervised by the ECB; as of July 2017 this was 120 entities (in particular, it does not apply to funds, banks that do not take deposits, etc.). The ECB stressed the necessity of credit institutions proportionately applying the Guidance; taking into consideration the overall proportion of leveraged transactions in relation to the credit institutions’ assets, earning and capital. The ECB also encourages the Guidance’s application to other credit institution activities.
Implementation of the Guidance will be monitored by the joint supervisory team (the “JST”), who will receive report submissions from the supervised institutions. Monitoring of the Guidance, will occur through both on-site inspections and off-site investigations. The ECB will also regularly monitor the leveraging activities of interested parties, focusing on parties’ exposure, development and risk profile. Further, the Supervisory Review and Evaluation Process will also consider the Guidance.
What is a leveraged transaction?
Under the Guidance, each affected credit institution should introduce an ‘all encompassing’ definition of “leveraged transactions”. It should include aspects of geographical application and business units in order to provide management bodies with a comprehensive view of the leveraging activities.
The ECB has stated that credit institutions should consider anything meeting one of the following criteria as a “leveraged transaction”:
- where the borrower is owned by one or more financial sponsor (e.g. private equity firms); or
- where the leveraging is more than four times the Total Debt to EBITDA of the borrower. Further, the ECB concluded that highly leveraged transactions (ratio of above 6.0) should be of exceptional nature.
The ECB made several clarifications to assist credit institutions in determining what constitutes a "leveraged transaction”:
- the calculation of the threshold: the calculations should be made on a consolidated borrower's basis (to the extent that intra-group support cannon be assumed upon occurrence of financial difficulties);
- leveraged structure of the borrowers: debt held by both banks and non-credit institutions should be taken into account;
- borrower liabilities: when calculating total debt, cash available should not be netted against the liabilities of the borrower;
- EBITDA adjustment: any adjustments to EBITDA, should be made by a unit which is separate from the front office;
- Total Debt: "Total Debt" shall encompass drawn and undrawn debt, together with any additional debt the loan agreement may permit.
The ECB provided specific exceptions to the definition of a "leveraged transaction". Such exceptions include loans with natural persons, credit institutions, investment firms, small value loans (under EUR 5 million); and loans designated as "specialised lending", investment grade loans and sovereign exposures. Specialised lending encompasses project, real estate, and commodities finance.
Expectations for credit institutions
Credit institutions are expected to define a scope for their approach and strategy when dealing with leveraged transactions, whereas this scope should also should set limits for these deals. Credit institutions should have a governance structure where senior management should oversee all leveraged transactions, and all such transactions shall be pre-approved by a separate risk unit.
The implementation of the Guidance will certainly result in increased scrutiny of leveraged transactions. Further, the Guidance’s instructions relating to higher leveraging levels may result in funds from credit institutions who are subject to monitoring being shifted to institutions not bound by the guidance, for instance non-Eurozone member states.
However, it is uncertain whether non-member state regulators will implement the Guidance in their national legislation. If they choose not to, then it may lead to a competitive advantage for banks located in non-Eurozone member states. The actions of the Bank of England post-BREXIT will also be of particular interest.
In theory, the introduction of the Guidance should also lead to a more competitive playing field between US and EU banks; however, the extent of this is unclear in the immediate future, particularly while we wait on the anticipated review of the US guidance. Additionally, whether the rate of leveraged transactions decreases as a result of the Guidance is another point to be closely observed.