Buyout Loans to Get Closer Scrutiny

Federal regulators have rewritten their guidance on leveraged financing, requiring more stress testing of loan portfolios and better-defined standa...
Vincent RyanMarch 27, 2012

Federal banking regulators want banks to tighten up the underwriting of loans used by many private-equity firms in buyout transactions. They are recommending more frequent stress testing of such specialized loans and want banks to delve deeper into whether the financial sponsor would inject capital into the borrowing company if it underperforms.

The three major banking regulators issued the proposed guidance on leveraged lending Monday. While the guidance is not law, it’s a good indication of the information examiners will regularly request from banks.

U.S. regulators are trying to prevent a repeat of 2006–2007, when aggressive underwriting led to so-called covenant-lite loans that provided banks little recourse when the recession hit and companies defaulted. According to regulators, the capital structures and repayment prospects for transactions then were too aggressive in light of many borrowers’ risk profiles.

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“Banks will have to establish an overall strategic level or ‘appetite’ for this kind of financing,” says James Defrantz, senior consultant at CCG Catalyst. “They better have a strategic plan, a plan for constant monitoring, and an exit plan.”

Companies and private-equity firms, meanwhile, may find it harder to get a bank to back their deal, as regulators want highly leveraged deals underwritten with an eye toward the borrower’s ability to fully pay back the debt or pare back its total debt in five to seven years.

One of the biggest changes in the guidance are suggestions for how banks should account for the financial condition of the buyout firm in their internal risk ratings. Banks usually analyze a loan based on the borrowers’ stand-alone financials, but they have been able to also consider a private-equity firm’s tendency and ability to “provide financial support” to an ailing investment.

The new guidance doesn’t change that. Still, it provides much more detail on how banks should evaluate that potential support. It suggests a periodic review of the buyout firm’s financial statements, liquidity, and its past practices with regard to dividends and capital contributions.

A big question for banks will be whether their IT systems can handle all the additional reporting and analytics bank examiners may request on leveraged loan portfolios. While some banks have the data needed to accurately assess their risk exposure to certain loan types and stress test against it, many bank systems are not sophisticated enough to even do simple things like aggregate risk exposure across product lines, says Christine Pratt, a senior analyst at Aite Group.

“If a construction firm has multiple commercial real estate and development loans with a bank and has a small business loan as well, many banks’ systems can’t tie that information together,” says Pratt.

Banks have until June 8 to comment on the first iteration of the leveraged financing guidance. In their response, banks are expected to say that any clampdown on leveraged loan underwriting will hamper their ability to finance mergers and acquisitions and impose more undue regulatory burdens on the industry.

But such guidance, especially that related to stress testing, can protect banks, points out Kimberly Songer, director of risk products at Harland Financial Solutions. “The idea is not to approve fewer loans,” wrote Songer in a recent blog. “A more effective portfolio analysis enables lenders to take action long before liquidation — requesting additional guarantees, business loan agreements, or collateral adjustments.”

The leveraged loan market has bounced bank from the depths of the credit crunch and a slight downturn last year. Companies issued $18 billion of highly leveraged debt in February — an eight-month high, according to S&P Leveraged Commentary and Data. Borrower default rates are low, and are expected to remain near 2% this year.

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