Private equity: bank regulators tighten the collar on leveraged loans

May 11, 2012
By Alex Lee

NEW YORK, May 11 (Business Law Currents) – With the leveraged finance market coming back to life, bank regulators want financial institutions to seriously tighten oversight and maintenance of their leveraged portfolios. Leveraged loans are heavily utilized by private equity shops for their transactional activities but there is an ever-increasing concern that while loan volume has gone up, underwriting practices have deteriorated to unacceptable standards.

On March 26, 2012, bank regulators released proposed guidance on leveraged lending for public comment. The Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency have proposed revising previous guidance issued in 2001 on leveraged finance as greater scrutiny is being placed on financial institution based risk factors. Proposals in this sector could potentially impact private equity shops by affecting one of their primary sources of funding for acquisition deals.

By way of background, as the acquisition finance market recuperated from the doldrums of the credit crisis, lenders increasingly locked in the types of commitment provisions that they were unable to in the earlier part of the decade. Pre-credit crisis borrower friendly provisions fell to the wayside and covenants became stricter and more lender friendly as the excesses largely disappeared.

In 2010, there was a strong rebound in the acquisition finance arena. As credit conditions improved, the optimism was reflected in greatly reduced loan default figures when compared to 2009. As the credit markets loosened up, there was a corresponding increase in the demand for more leverage utilization. Elevated market sentiment and increasing volume had buoyant effects for borrowers seeking financing commitments.

Private equity sponsors, flush with the capital they needed to deploy, helped drive the demand for debt commitments. Negotiations for debt facilities replicated the non-bespoke, precedent driven deal processes seen prior to the credit crisis. This was no surprise as lenders were keen to make investments with ever higher returns and the competition between them only added to deal making urgency and the superior position sponsors found themselves in.

Now, as in 2010, private equity is an awakening giant with highly elevated levels of LBO activity materializing due to improved acquisition finance markets. As credit markets eased in the first half of 2011 and borrower friendlier terms developed, deals kicked off at a nice pace. This increase in deal activity has led the bank regulators to seek public commentary on their proposals as they fear is that although volume has risen, the corresponding underwriting quality has declined.

The general fear is that if prudent underwriting continues to diminish, there may be a seriously detrimental increase in system wide exposures to credits. This scenario would in part be caused by a return to pre-credit crisis type deals that were more precedent driven cov-lite transactions that also stripped protective provisions for lenders down to bare minimum levels. If debt facilities continue to exhibit reduced lender protection, deals could be structured too aggressively and financial institutions could fail to properly manage their exposures.

Cov-lite structuring has a storied history that helped influence the bank regulators’ recent proposals. With the advent of the credit crisis, the general view of the markets was that banks would no longer offer debt financing though cov-lite structures. Prior to the credit crisis, borrowers negotiated looser terms to take advantage of the oversupply of lender capital relative to lesser demand from borrowers.

In order to increase margins by even the thinnest of slivers, pre-crisis banks and investors eagerly jumped on the cov-lite wagon, often forgoing the usual slew of protection provisions. The oversupply of capital coupled with a depressed merger and acquisition climate allowed major corporate borrowers, sponsored borrowers and well-regarded leveraged borrowers to tap the cov-lite market at will.

Although cov-lite transactions are exhibiting strong signs of resurgence, it is now a slightly different beast. Prior to the credit crisis, credit facilities effectively contained no financial maintenance covenants, regardless of the type of facility. In the current climate, the banks once burned on the credit stove are now insisting upon the inclusion of fuller financial ratios in credit facilities. The leverage ratios are not generally tested on a periodic timeframe and borrowers must show compliance on a pro forma basis for the incurrence of pre-specified events.

Today’s cov-lite loans are tighter than their pre-credit crisis counterparts. The lack of financial maintenance covenants and significantly looser negative covenants means, however, that lenders no longer have the long teeth they once had even though they are provisionally protecting their interests more. Nonetheless, cov-lite loans are a far cry from a lender friendlier credit facility such as Alliance HealthCare Services’ where we see a more typical offering of financial covenants such as a minimum interest cover ratio and a maximum leverage ratio. A good example of a tighter agreement is General Maritime’s $1.12 billion worth of credit facilities.

During the credit crisis when the debt markets were effectively shut off, there was little impetus to refine guidance on leveraged finance. As the economy continues to show signs of resuscitation and private equity-driven transactions rebound, bank regulators fear that there could be a market return to cov-lite. The bank regulators have decided that now is the time to refurbish their previous guidance to enhance their supervisory capacity with respect to regulated financial institutions.

The bank regulators have broadly proposed areas of concern relative to financial institutions and want to ensure that financial institutions can: properly assess and monitor credit risks; ensure that borrowers have sustainable capital structures; comprehend the impacts of borrower distress; and include stress testing and sensitivity analysis in their overall risk management schemes. The ultimate goal of regulators is to have financial institutions in a position to adequately monitor their leveraged portfolios so that necessary protections can be entrenched before borrowers plunge into financial difficulties.

Bank regulators want financial institutions to properly report on internal controls when they are exposed to leveraged credits. This would be conducted mostly through comprehensive credit analysis processes, heavy monitoring and fully detailed reports on their portfolios.

If the revised guidance becomes finalized, bank regulators will be in a position to assess whether or not financial institutions are in compliance with leveraged finance standards. Many analysts have stated that riskier cov-lite loans will make a big comeback as the financial environment improves and M&A activity returns to healthy levels. Although this analysis is sound, the reality is that the “form and substance” of future cov-lite deals remains to be seen. Although cov-lite deals are still prominent in the markets, they are not nearly the aggressive, borrower friendly facilities from prior to the credit crisis.

As bank regulators want to ensure that boom time aggressive lending practices are curbed, there is something to be said for self-policing, as banks are now far more wary of covenant loose deals. It appears that the real fear is that as the economy improves, lenders will once again fall into the position of competing with each other to provide credits in a sponsor/borrower friendly environment. In that type of atmosphere, the natural progression of lender protections is one that spirals downwards.

Bank regulators have stated that they will continue to closely monitor the leveraged finance market in the future, and if necessary, speak out forcefully if pressure continues and does not ease. While the guidance itself is not enforceable, it does delineate acceptable best practices and gives examiners necessary structure with which to screen leveraged finance exposures. As the transactional markets show signs of returning to healthier levels, the guidance will likely have more bite if the financial institutions do not police themselves in a satisfactory manner.

(With contributions by Harvie Haun, Business Law Advisor.)

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at


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