Leveraged buyouts were a symbol of the boom ahead of the global financial crisis. Eight years on and leveraged loans are back, but this time regulators are keen to curb bankers’ enthusiasm.
The power of leverage has been known since the days of Ancient Greece. The mathematician Archimedes said some 2,200 years ago: “Give me a place to stand and with a lever I will move the whole world.”
During the financial boom years of the three decades in the run-up to 2007, corporate executives and bankers took those words to heart, using a significant amount of borrowed money to finance the cost of multi-billion dollar acquisitions and giving birth to the concept of the leveraged buyout.
But since the global financial crisis of 2008–09, regulators across the Western world, and particularly in the US, have become more wary of the ability of leverage to magnify risk as well as borrowers’ firepower.
The fall in official US Federal Reserve interest rates to close to zero, combined with its quantitative easing programme, created vast swathes of cheap financing that has triggered a surge in leveraged lending to rival the pre-crash volumes.
In March 2013, the Fed and the Office of the Comptroller of the Currency separately published guidelines to govern the sorts of loans banks would be able to make to debt-laden companies, as they sought to prevent credit markets again overheating.
In particular, the moves flagged up leverage of more than six times Ebitda as something that could trigger penalties.
In the autumn of that year, the Fed used its annual stress-test scenarios for banks, including factors that would test a bank’s response to changes in economic conditions that might affect the performance of leveraged and other high-risk loans.
Then in a “frequently asked questions” publication released in November 2014 it flagged up concerns over covenant-lite leveraged loans that had fewer restrictions on collateral, payment terms, and levels of income.
The actions appear to have worked to limit the growth in US leveraged loans, falling from US$292.6bn in the first quarter of 2014 to US$125.7bn, according to data from Thomson Reuters.
US LBOs funded using those loans also eased from US$21.1bn to US$19.0bn over the same period.
Jeff Norton, US banking partner at global law firm Linklaters, said that regulation was certainly “top of mind” for all participants in new deals.
“People are slightly more mindful about the amount of leverage, the covenant approach and other things the regulators are concerned about, but there has yet to be a significant change in overall approach,” he said.
The scale of leverage has been reduced. According to Thomson Reuters data, at the end of last year, the largest corporate leveraged buyout deals in the final quarter of 2014 carried debt of 6.54 times earnings, on average. This was down from 6.96 times in the third quarter, which was the highest level of holdings since they averaged above seven times during most of 2007.
Other regulations are also acting as a brake on leveraged deals. Regulations such as the Volcker Rule, Dodd-Frank’s risk-retention rules, and Basel III capital requirements have dampened issuance in the leveraged finance market, with the prospects of compliance making arrangers and borrowers reluctant to bring new deals to market.
According to Standard & Poor’s Capital IQ Leveraged Commentary & Data, arrangers of transactions expect acquisition-driven loan volume to continue at the pace seen so far in 2015, with an emphasis on strategic deals.
“As for leveraged buyouts, the calendar may be spottier, in part because of high stock-market valuations,” said Andrew Watt, a primary credit analyst at the ratings agency.
While US leveraged loans may be declining as a source of financing, it has hardly brought deal-making to a halt. The deal momentum accelerated towards the end of the first quarter of 2015.
Highlight deals included loans raised for the financing of the acquisitions of retailer Petsmart (US$4.3bn), Riverbed Technologies (£1.6bn) and packaging firm SIG Combibloc (US$1.2bn).
But what each of these transactions had in common was that the banks providing the funding for these transactions adjusted the financing terms to get the deals through.
In the case of PetSmart, leverage ratios estimated as high as 7.25 prompted several banks to stay away from the deal. However, the deal went through in February 2015 with Citigroup, Barclays, Deutsche Bank, Nomura, Jefferies, RBC Capital Markets, and Macquarie arranging the loan.
Banks are likely to be concerned about antagonising the Fed over the issue, if for no other reason than that all US banks have complex relationships with the Fed and want to ensure those relationships remain friendly and avoid any potential point of tension..
“Therefore, there is a balancing act involved as to what you are doing with your leveraged loan desk and what you might be doing with other parts of your business that touch on the Fed,” said a senior loan banker.
But as US banks have withdrawn from some high-leveraged deals, other lenders such as private equity firms have been more than happy to fill the breach.
When Preferred Sands, a maker of sand used in hydraulic fracturing, came close to bankruptcy in the summer of 2014, US banks were uneasy about offering refinancing at high leverage.
KKR, the US private equity giant, agreed to refinance the company through equity and debt of more than US$680m. Deals are being done.
“I can’t say that increased regulatory concern in the US has had a chilling effect, given the market is still very active and highly competitive,” said Norton.
He added that there had been some deals where there had been a reluctance to agree to certain terms for certain banks that have pulled back for a bit.
“There have been a few recent deals where there has been initial reluctance to agree to certain terms, however this usually is sorted through,” he said.
For example S&P LCD identified a weakening in a key leveraged loan covenant protection. The percentage of leveraged loans that waive excess cashflow recaptures – covenants that force borrowers to repay debts ahead of schedule – reached an all-time high of 42% in the first quarter of 2015.
James Douglas, global head of debt capital advisory at Deloitte, said he still saw “huge liquidity” in the global leveraged loan market.
“In particular, the non-bank alternative lender space is incredibly buoyant,” he said. “There is a significant volume of alternative lender money looking for leveraged loan opportunities.”
Leveraged loans are now increasingly popular in Europe as there has been a shift away from traditional bank lending towards institutional leveraged loan issuance.
Data from Deloitte showed that in Europe in the third quarter of 2014 there were 80 deals financed by alternative lenders compared with 18 in the fourth quarter of 2014.
One trend that Norton had observed was that there were more deals done in the US style or using US law in order to tap into the US markets and also to reflect preferred precedents for transactions.
“There is a lot of mixing of structures and precedents across markets,” he said.
Flavour of the day
Transactions being negotiated in financial centres such as Hong Kong, Paris and London will increasingly be based on the structure of the US market.
“It seems to be the flavour of the day right now to make sure your loan is sellable in Europe, Asia and in the US,” said the senior loan banker.
Meanwhile, there are signs that banks are becoming keener to compete for leveraged loans. JP Morgan is leading a refinancing for sales and marketing agency Acosta, which aims to cut the company’s borrowing cost.
The loan, which was originally syndicated in August 2014 before regulators tightened the reins on Wall Street lenders, has total leverage of 7.6 times and senior leverage of 5.2 times, bankers said.
On the same day in November 2014 that the Fed issued its frequently asked questions, its Shared National Credit review showed that leveraged loans accounted for almost three-quarters (74.7%) of criticised assets.
One in three leveraged loans were criticised by the Fed and the other federal banking agencies.
“The review also found serious deficiencies in underwriting standards and risk management of leveraged loans,” it said. “Overall, the SNC review showed gaps between industry practices and the expectations for safe-and-sound banking articulated in the 2013 guidance.”
This has raised concerns that the regulators may continue to tighten their control on leveraged loans. The senior loan banker said there was still not a “bright line test” – the phrase the Fed used in its November FAQ – that indicated a point that bankers could not cross. “If we started moving towards that, then that would certainly have an impact.”
Meanwhile, with M&A deals enjoying a boom, Norton said bankers and financiers would look at other forms of finance such as high-yield debt to get the deal done. To borrow from Archimedes’ principle, regulation in one part of the market will displace the liquidity elsewhere.