Many mainstream publications, including The Wall Street Journal and Reuters, have recently written about what had previously been an obscure corner of the bank regulatory world: the Supervisory Interagency Guidance on Leverage Lending (the “Guidance”) issued by the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (the “Agencies”). What’s going on?
As we noted in our Spring 2013 Issue of the Debevoise & Plimpton Private Equity Report,1 in March of 2013, the Guidance modified previously issued regulatory guidance in meaningful ways and, in particular, set forth in new detail certain expectations with respect to the factors a financial institution must consider in its underwriting process, including, among other factors:
- the borrower’s leverage, noting that leverage in excess of 6X total debt/EBITDA raises concerns for most industries;
- whether the borrower has the ability to fully amortize its senior secured debt, or repay a significant portion (e.g., 50%) of its total debt, over the medium term (i.e., 5-7 years) using free cash flow;
- whether the credit agreement contains adequate covenant protections, including financial maintenance covenants; and
- whether the credit agreement allows for the material dilution, sale or exchange of collateral or cash flow producing assets without lender approval.
None of this is new. What is potentially new is that the Agencies have recently made clear their intention to scrutinize leveraged lending practices more closely based on the Guidance. The publications noted above, among others, have reported that the Agencies have sent individualized letters to various financial institutions highlighting this message. Further, certain representatives of the Office of the Comptroller of the Currency have been particularly vocal on the topic, stating that the impact of the Guidance on private equity is an intended consequence of the Agencies’ actions and that the Agencies have many tools available to deter the origination of criticized loans, alluding to enforcement orders and supervisory ratings. Although the verdict is not yet in, anecdotal evidence suggests that all of this attention may be starting to have an impact. Various reports (some, but not all, of which may be urban legends) suggest that one or more banks has pulled out of a highly leveraged deal, or insisted on certain lender-friendly terms, at least in part due to the Guidance.
While the full implications of the Guidance and the changes that regulated financial institutions will make in response still remain to be seen, as we have noted previously, it is possible that the Guidance could have a meaningful impact on regulated institutions’ willingness to participate in highly leveraged transactions and could lead to an increased role in the leveraged lending market for unregulated (or less regulated) providers of financing, such as private funds, as well as for less regulated financing products, such as high yield bonds. While these developments would face impediments, these providers and products could become a relatively more attractive alternative to bank-provided leveraged loans in future leveraged financing transactions.
1 "Alert: New Banking Guidance May Impact Leveraged Lending," The Debevoise & Plimpton Private Equity Report, Spring 2013