Smaller LBOs may fall victim to new lending guidelines

US regulators are ramping up pressure on banks to curb high-risk lending that triggered the financial crisis, including leveraged loans that finance acquisitions and dividend payments.

A Federal Reserve advisory sent to U.S. banks in March was followed up with individual letters to European banks by the Office of the Comptroller, asking them to explain their risk management policies.

“There is a huge amount of talk about this in the market. Because the Fed can’t raise interest rates, which is one way to slow down systemic risk, they are looking at other ways to do that and have decided on leveraged lending,” said one market source.

Three main parameters—including leverage and the ability to pay down loans—will be used by the regulators to determine whether any debt is classified as a “criticized loan”.

But banks are grappling with what exactly passes or fails the test. With so much open to interpretation, some are already pulling back from lending.

“Every bank wants to be on the sponsors’ lists. But we are thinking about how this will impact us,” said one debt capital markets banker.

“We don’t want to be the bank underwriting the most leveraged deals, but we don’t want to be at the bottom of the table doing none of this business either.”

One bank that had offered a debt commitment for one potential leveraged buyout that is not yet public actually dropped out last month after reviewing the loans and concluding they would be deemed too aggressive, the source said.

“Decisions are going all the way up to the board.”

Rear View Mirror

It is not known if a loan will be deemed “criticized” if it fails one, two or all of the guidelines, nor is it clear what amount of loans a bank can have on its balance sheet.

Loans may be criticized for repayment risk if a company fails to show the ability to amortize all senior debt or half of total debt from free cash flow within five to seven years.

Top on the hit list of regulatory concerns are: excessive leverage, inability to amortize debt over a reasonable period and a lack of meaningful financial covenants.

“We all want to know what the regulators will think is more important when they look back in the rear view mirror,” said another debt capital markets banker.

“Some banks think that it will be leverage multiples, and others the pay-down concept.”

One of the most worrying factors for banks is that they will also be penalized if they distribute deals, even if there are buyside accounts that want to buy the debt.

Overall, the guidelines present another obstacle for boosting LBO volumes, as banks focus more on big deals that generate more fees and skew away from middle market ones.

A More Obvious Choice

Although there have been very few buyouts in 2013 that would have fallen foul of the guidelines (at least in the bond market), it will be tough to bring deals with more leverage than six times earnings multiples going forward.

More aggressive structures that include second lien loans that are tougher to pay down will also likely be harder to justify under this close scrutiny, said one of the sources.

But one silver lining could be that the high-yield bond market, like bridge loans, is not included in these guidelines. “If an all-bond capital structure works for a buyout, then people may decide to go down that route,” said the first source.

The second debt capital markets banker said floating rate notes, often compared to covenant-lite loans but not a big component of high-yield bond supply up to now, may start to rise in popularity.

“There’s so much demand for FRNs (floating rate notes) out there, but it’s been hard to convince issuers to do them. This may well facilitate secured FRN bond issuance.”

Winners And Losers

Private equity firms know that some banks will turn their business away and inevitably will broaden the number of lenders that they speak to.

There is also a chance that some of the bigger private equity houses, including Apollo Global Management, Ares Management, The Blackstone Group and Kohlberg Kravis Roberts & Co—as competitors to the banks—could benefit from the changing dynamics if they increase direct lending to middle-market companies through their specialty finance arms.

The same goes for big asset managers like BlackRock, some said.

“That will be on the margin though. They talk to 10 accounts on a regular basis, whereas the banks talk to more like 180 accounts, and they will probably still need banks for the revolvers,” said the second debt capital markets banker.

“These guidelines put a real cap on the size of deals that can get done.”

In the longer term, less debt could actually help propel leveraged buyouts if it brings buyers’ and sellers’ price expectations closer together, something that has hindered deals in the last couple of years.

“Over time, and it will probably be a fair amount of time, this could compress values,” the second banker said. “Less debt means less leverage, so prices will have to come down.”

Natalie Harrison is a chief correspondent for sister magazine IFR