Risk Management

Regulators Hoist Bar for Leveraged Borrowers

By setting new standards for bank underwriting, three federal agencies ensure private-equity firms and companies will have to meet higher standards...
Vincent RyanMarch 22, 2013

U.S. banking regulators on Thursday published revised and final guidance for financial institutions that originate leveraged loans as part of an effort to rein in aggressive underwriting of the instruments that underpin many private-equity buyouts.

The new guidance, which is not law, increases some of the analysis and monitoring banks have to do around a loan that raises the debt on a borrower’s balance sheet to “above industry norms.” The guidance could eventually dampen financial institutions’ appetite for financing leveraged buyouts and make it more difficult for already highly leveraged firms to refinance their debt.

Leveraged credit transactions boomed before the financial crisis and then declined, but the regulators clearly believe the measures are timely and will prevent banks from gorging on these risky credits again. In a statement released Thursday, the Federal Reserve Board, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency said, “While leveraged lending declined during the crisis, volumes have since increased and prudent underwriting practices have deteriorated. For example, some debt agreements have included features that weaken lender protection by excluding meaningful maintenance covenants and including other features that can limit lenders’ recourse in the event of weakened borrower performance.”

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The final guidance, which replaces the one issued in April 2001, emphasizes several new areas that banks will have to focus on when underwriting, monitoring, and valuing leveraged loans. When the initial proposal was released last March, several provisions irked banks. While regulators conceded on some details in the final document, for the most part they stuck to the spirit of the new standards.

One stipulation that worried banks required that they do a lot more digging into the financials of any private-equity firm involved in a deal. The revised guidance says only PE firms designated as a secondary source of repayment on the loan will be subject to deeper scrutiny. The scrutiny will have to include the sponsor’s historical performance in supporting its investments; “periodic review of the sponsor’s financial statements and trends, and an analysis of its liquidity, including the ability to fund multiple deals”; and “the likelihood of the sponsor supporting a particular borrower compared to other deals in the sponsor’s portfolio.”

The agencies also stuck to a new standard that bank examiners will use to define high leverage. While bankers did not want a “bright line” around leverage, supervisors declared that transactions in which the borrower’s total debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) exceeds 4.0 times or its senior debt-to-EBITDA exceeds 3.0 times are leveraged deals.

The three agencies did clarify the guidance in two ways that financial institutions will welcome. First, they excluded so-called fallen angels from the definition of leveraged borrowers. These borrowers are not highly leveraged at the time of a loan’s origin but “migrate” into that class at a later date because their company’s financial condition deteriorates. “A loan should be designated as leveraged only at the time of origination, modification, extension, or refinance,” the revised guidance reads.

The agencies also reassured smaller banks that a financial institution that originates only a handful of relatively simple leveraged loans should not be affected by the guidance. However, the guidance does say that banks that purchase “participations” in leveraged loans — which some community banks do — should apply the same lending standards they would if they were originating the loan.

The guidance is effective on March 22, 2013, and the compliance date is May 21, 2013, according to the Federal Reserve statement.