As most private equity professionals are aware, in the spring of 2013 the Federal Reserve Board (the “FRB”), the Federal Deposit Insurance Corporation (the "FDIC") and the Office of the Comptroller of the Currency (the “OCC”) (collectively, the “Agencies”) issued the final version of their Interagency Guidance on Leveraged Lending (the “Guidance”). The Guidance includes two critical metrics: (1) a borrower should be able to fully amortize its senior secured debt, or a significant portion (e.g., 50%) of its total debt, over the medium term (i.e., 5-7 years) using free cash flow and (2) borrower leverage levels of greater than 6x total debt to EBITDA “raise concerns” for borrowers in “most industries.”
Anecdotal evidence suggests that the Guidance has led to meaningful tightening in underwriting standards at regulated institutions and lower leverage levels in the leveraged lending market generally; for example, average leverage multiples have dropped from 6.26x in 3Q14 to 5.6x in 1Q15. In the context of frothy equity valuations and robust purchase price multiples, the leverage limits and repayment requirements imposed by the Guidance disadvantage potential acquirers that rely more heavily on the leveraged lending market (i.e., private equity and other below investment grade buyers) relative to other potential acquirers (i.e., investment grade or public company buyers), particularly if those buyers are able to fund a portion of the acquisition consideration with their own highly valued stock. While M&A activity is on a record pace in the first quarter of 2015, volumes in the debt financing markets have been decidedly skewed in favor of investment grade acquisition financings (an increase of 19% from the previous year) and against leveraged acquisition financing markets (a decrease of 13% from the previous year).
Competitive Imbalance: Structuring Responses and Limitations
In response to this competitive imbalance, some market participants (particularly private equity sponsors) have considered (and in some cases successfully executed) structural alternatives to increase leverage levels to meet sellers’ price expectations while maintaining desired investment returns. Although such creative structuring has enjoyed limited success, several factors have impeded more fundamental shifts in the leveraged acquisition financing markets away from leveraged loans in favor of high-yield bonds and away from regulated institutions to unregulated institutions.
In addition, notwithstanding the availability of structures that may be compliant with the express language of the Guidance, regulated institutions are reluctant to participate in such structures. The Agencies have made clear that they are approaching the leveraged lending market from a “macroprudential” perspective, i.e., by regulating markets to mitigate perceived systemic risks, and not only risks to the financial institutions regulated by the Agencies. Given the Agencies’ broad regulatory authority over significant participants in the U.S. leveraged lending market, as well as the Agencies’ seriousness of purpose and willingness to take supervisory action, institutions subject to the Guidance are reluctant to be viewed as avoiding (or facilitating avoidance of) the Guidance through creative structuring. Against this backdrop, we describe below potential structuring alternatives that market participants have considered in response to the Guidance. Each involves risks, complexities and costs that would not be present in a traditional leveraged financing transaction.
Unregulated originators (i.e., market participants not subject to the supervisory jurisdiction of the Agencies) are not subject to the Guidance and can offer for their own account, or arrange, more highly levered acquisition financing packages than the Guidance permits. As a result, some commentators have predicted a relatively larger role in the leveraged finance market for loans arranged by less-regulated providers. This trend has been evident in the market, and we expect it to continue for the short to medium term (e.g., during 1Q14, Jefferies was the only non-bank originator to appear in the top ten of the Thompson Reuters LBO Bookrunner League Tables; during 1Q15, Macquarie and Nomura joined Jefferies in the top ten). However, there are limits on this market transition:
- Unregulated entities typically have less developed syndication infrastructures and expertise than regulated financial institutions. Private equity sponsors and other leveraged borrowers may be reluctant to entrust large and complicated debt financings, in which syndication execution is critical, to unregulated institutions. Moreover, sellers and borrowers in major transactions may have concerns regarding the creditworthiness of certain unregulated lenders and the reliability of their commitments to fund the debt financing. This concern could put a potential buyer relying on debt financing from unregulated arrangers at a competitive disadvantage to those with committed financing from traditional sources and, therefore, should be considered carefully by bidders (and sellers) in competitive auctions.
- Discerning borrowers may be wary of relying on revolving credit commitments from unregulated financing sources for critical working capital and other liquidity needs over the term of the facility. Unregulated originators generally lack a full-service depository institution and, therefore, may be unable to provide the same balance sheet support as a traditional bank. Sourcing revolving commitments from regulated institutions is not a solution to the limitations imposed by the Guidance; the Agencies have been clear that if any portion of the debt capital structure is subject to the Guidance because it is provided by regulated institutions, the entire structure will be subject. Some unregulated originators have teamed with unregulated financial institutions with strong balance sheets in response, with varying success. Another potential solution is funding debt proceeds to the balance sheet of the borrower (e.g., by way of funded term loans or high-yield bonds) for future working capital and other liquidity purposes. This approach carries additional costs beyond that of a traditional unfunded revolving credit facility.
- Unregulated originators rarely have the capacity to issue letters of credit, again because they generally lack full-service bank affiliates. There are other solutions (e.g., cash collateralizing), which also involve incremental costs.
Each of the aforementioned concerns is more acute in acquisition financings, as opposed to refinancings of existing debt capital structures (assuming the existing revolving facility can remain outstanding without being refinanced, amended or waived). While this may appear to be a very thin silver lining in an otherwise cloudy sky, it is worth spotting. The Agencies have been clear that the Guidance applies to refinancings and restructurings of existing credits, including those that do not meet the Guidance (“Non-Pass Credits”). While the Agencies have noted that the Guidance is not intended to discourage institutions from refinancing Non-Pass Credits, they have also stated that such refinanced credits should be strengthened by way of “meaningful improvements in structure or controls.” These improvements may include the addition of new covenants or the tightening of existing covenants, additional equity injections, line reductions, increased amortization, addition of collateral or restrictions on new acquisitions or issuance of additional debt (i.e., mere reductions in interest rate, extensions of maturity or decreases in bank exposure will not suffice). This type of credit enhancement is unlikely to be attractive to many leveraged borrowers.
Bond Offerings; ABLs
High-yield bond offerings are outside the direct scope of the Guidance, to the extent they take place in broker-dealers regulated by the Securities and Exchange Commission. Instead, the issuance and sale of these securities are subject to federal and state securities regulations that generally address investment risk issues through detailed disclosure to sophisticated investors. In contrast to the Guidance, securities regulations impose no leverage limits or repayment requirements and leave the investment decision to investors, as long as there has been appropriate disclosure. As a result, market participants have theorized that high-yield bonds and other structures involving broker-dealers could replace leveraged loans that would be subject to the Guidance in a typical acquisition financing. The bonds could be structured to mimic term loans (e.g., secured, with a floating interest rate and call protection more similar to term loans than to traditional high-yield bonds). There are impediments to this approach, however.
- First, one must confront the issues noted above regarding working capital and other liquidity needs of the borrower. In a high-yield bond offering, in addition to the potential structuring solutions outlined above, it may be possible for regulated institutions to provide such a liquidity facility in the form of asset-based loans (“ABL”), which the Agencies have noted may not be subject to the Guidance if they are the dominant source of funding for a borrower. While this statement appears to leave open the possibility that a capital structure using an ABL revolver in combination with a financing product outside the direct scope of the Guidance (e.g., high-yield bonds) may be workable, regulated institutions may shy away from this structure for fear of running afoul of the Agencies’ macroprudential policy intent.
- Further, in a committed (as opposed to best efforts) financing, the committed debt is a bridge loan and not high-yield bonds. The Agencies have reportedly informed regulated institutions that a committed bridge loan, and thus the entire debt capital structure, would be subject to the Guidance. Some have queried whether the bridge loan can be replaced by a forward underwritten high-yield bond offering. However, a forward underwriting structure may present other issues, including under other regulatory regimes (e.g., the Volcker Rule’s restrictions on proprietary trading).
- Moreover, marketing and syndication practices with respect to debt securities and bank loans differ significantly. As noted above, the securities regulatory regime is based on extensive disclosure (including 10b-5 liability for material misstatements and omissions) and, thus, securities offering documents are often dense, highly engineered and time consuming to produce. In contrast, bank loan marketing documents are traditionally less comprehensive and can, when necessary, be produced on a much tighter time frame. “Bridge teasers” (i.e., the documents used to syndicate bridge loan commitments) often take the form of slide decks and can be produced in a matter of days. Arrangers may not be amenable to a forward underwritten bond offering, even if structured to meet regulatory and other hurdles, because of these marketing implications.
- Finally, many of the most significant broker-dealers, although not directly subject to Agency jurisdiction, are part of a corporate group subject to consolidated supervision by the FRB. These corporate groups may steer clear of structuring alternatives involving their broker-dealers for fear of an adverse supervisory reaction.
Another structure that has been deployed to address limitations imposed by the Guidance is incurring a portion of the debt (the “Holdco Facility”) that might otherwise be funded at the operating company level (e.g., leverage above 6x) at a direct or indirect holding company of the operating company, which is outside the credit group (i.e., it does not provide a guarantee or other credit support in connection with the operating company facility (the “Opco Facility”)). The Holdco Facility might be structured as debt or preferred stock depending on commercial, tax and other considerations but, in any event, it would be structurally subordinated to the Opco Facility and, therefore, subject to certain exceptions noted below, should be treated as common equity and ignored for purposes of compliance with the Guidance. One aspect of a Holdco Facility that, arguably, should be considered in determining compliance with the Guidance is any impact the anticipated payment of interest and principal on the Holdco Facility might have on the operating company’s ability to meet the repayment test under the Guidance. The prospective borrower should expect that (1) assumptions will be made with respect to the repayment of the Holdco Facility, (2) those assumptions will be unfavorable to the borrower group (e.g., that all available restricted payment capacity under the Opco Facility will be used to prepay the Holdco Facility, even if the holdco debt is pay-in-kind) and (3) those assumptions will be reflected in the model used to determine compliance with the repayment test under the Guidance. Further, experience suggests that regulated institutions interpret the Guidance differently with respect to whether Holdco financings should be included or excluded for purposes of determining compliance. Some regulated institutions are more receptive to this structuring alternative than others. Regardless of whether regulated institutions and the Agencies acknowledge the structurally subordinated nature of a Holdco Facility, the institutions extending credit certainly do and, as a result, this structure likely involves incremental costs.
Creative Structuring But Limited Success
These and other structuring alternatives could ameliorate the competitive imbalance that currently exists between private equity sponsors and other potential buyers that has been exacerbated by the leverage and repayment tests imposed by the Guidance. However, because of the limitations noted above – including most importantly the Agencies’ articulated macroprudential regulatory intent and broad authority over many of the most significant participants in the U.S. leveraged lending market – such structuring alternatives have met with limited success. Whether market realities, in the form of the upcoming refinancing wave, force the Agencies and regulated institutions to become more flexible with respect to these structures remains to be seen.