End of leveraged lending rule could increase competition, keep multiples high

  • Limit on bank lending to indebted companies now subject to congressional review
  • More leveraged lending by banks could help sustain high private equity multiples
  • Competition could increase, pressuring pricing and covenants

Federal guidance on leveraged lending could be the next Barack Obama-era banking regulation to fall, and the consequences might include “a war of attrition between traditional lenders and non-bank lenders.”

That’s according to Basil Karampelas, a managing director in BDO’s restructuring and turnaround practice, who said some banks have been lobbying for the rule to be rolled back. “Many of them, post-financial crisis, have seen both their commodity trading and their investment banking revenues decline significantly, and so they see an opportunity to make money providing additional volumes of leveraged loans,” he said.

Unregulated lenders vs. banks

With unregulated lenders having moved aggressively into the space, banks could be looking to regain some of their eroded market share.

The recommendations in question, adopted in March 2013, recommend banks not lend to companies with a debt-to-earnings ratio of six times or greater, or to borrowers that can’t demonstrate an ability to pay back in a timely fashion.

In March of this year, Senator Pat Toomey (R-Pennsylvania) asked the Government Accountability Office to decide whether the guidance was a rule for purposes of the Congressional Review Act. If so, it could be voted down by majorities in both houses of Congress. On Oct. 19, the agency responded in the affirmative, setting the stage for Republican lawmakers to pass such a joint resolution of disapproval.

The rule’s demise could make credit, already abundant, even more readily available. “If you’re a private equity player, you will likely find an even more competitive environment, to your benefit, in terms of firms willing to provide the debt that you need to get your deals done,” Karampelas said. “This ruling could help sustain the healthy price multiples being paid by private equity for transactions, at least in the near term.”

Helping sustain those prices are the heaps of dry powder amassed by private debt funds — $229.5 billion in total as of this month, according to data provider Preqin. Karampelas called the number of PE firms that now have at least one such fund “kind of staggering.” Along with stand-alone direct lenders that have emerged since the crisis, “they’re all hungry for deals, they’re all looking to deploy capital.” Many are hiring business development or origination professionals to help source investments and start drawing fees: “Finding the deals has emerged as equally important as being able to actually execute the deals.”

“Everybody’s trying to put that money to work,” said Dan DiDomenico, senior managing director at valuations provider Murray Devine. “We’re seeing a lot of money flow into this space, both domestically as well as managers establishing new funds overseas, in Europe or in Asia.” Rates are so low in other markets that foreign investors have “a big appetite” for U.S. deals.

As that demand pushes interest rates down, “the cheap debt that’s out there is keeping the multiples that private equity is willing to pay on the higher side,” DiDomenico said. In addition, lenders are willing to go “a little deeper into the capital structure. We’re seeing senior lenders going into four, five, six times [earnings] in some cases, and some additional mezzanine-type debt on top of that.”

Increasing credit risk

As well as supporting high multiples, that kind of leverage is probably increasing credit risk slightly, DiDomenico said. But “right now, most of the companies that we see are doing pretty well,” with less than 5 percent of loans qualifying as truly troubled. That, of course, could change if the economy starts to deteriorate.

According to Karampelas, the private-credit craze could end up falling far short of expectations. “You may find a number of the funds returning some or all the capital they’ve raised back to their investors because there simply isn’t the capacity to deploy all of it in an economic way. We’ve seen that before on the private equity side.”

For banks, the competitiveness of the market means pressure to move into more covenant-lite territory, where lenders have fewer protections. Karampelas expects banks to expand their offerings at the larger end of the spectrum, since it’s difficult for them to be competitive lending relatively small amounts.

But with interest rates on leveraged loans still very low, profits could be disappointing. “Because they’re not offering the same broad suite — commodity trading, FX, investment banking — that leaves less cushion for them if their lending business is not performing well,” Karampelas said.

Action Item: Read the GAO’s decision on federal leveraged lending guidance here.

Gene L. Dodaro, nominated by President Obama, is the eighth U.S. comptroller general and head of the Government Accountability Office. Photo sourced from the GAO website.