NEW YORK, Sept 26 (LPC) – US government agencies have opened the door to bigger, more highly leveraged loans backing private equity buyouts after clarifying that supervisory guidance is not a rule in mid-September.
The US loan market has treated leveraged lending guidance as a rule since it was updated in 2013 as regulators tried to curb systemic risk. Many banks received warnings about deals that the agencies viewed as non-compliant.
Some banks are producing more aggressive loans as the market heats up to cater to red-hot investor demand for floating-rate debt, and that may pick up even more now that regulation does not carry the weight of a law.
“In a sense the statement is extraordinary and a concession of regulatory power,” said J. Paul Forrester, a partner at law firm Mayer Brown.
In a joint statement in mid-September, federal agencies including the Federal Reserve (Fed) and the Office of the Comptroller of the Currency (OCC) said that guidance does not have the force and effect of a law, and agencies will not take enforcement action based on it. Guidance, they said, outlines supervisory expectations or priorities and articulates regulators’ views on appropriate practices.
“Previously there was every indication that such guidance had the force and effect of law, including the issuance of [Matters Requiring Immediate Attention (MRIA)] and similar notices to financial institutions,” Forrester said.
The US$1trn US leveraged loan market, which finances companies including American Airlines and retailer Party City, has recently been flooded with aggressive deals featuring high debt levels and loose terms.
Leverage, which is debt compared to earnings before interest, tax, depreciation and amortization (Ebitda), for buyouts increased to 7.09 times this quarter, which is the first time it has exceeded 7.0 times since the fourth quarter of 2007, according to LPC data.
Leverage topped 7.0 times for Blackstone Group’s US$20bn purchase of a 55% stake in Thomson Reuters’ Financial & Risk business, which will be re-named Refinitiv and includes LPC. In one of the largest buyouts since the credit crisis,
Moody’s Investors Service said leverage was 7.6 times as of June 30, while the private equity firm says total leverage is 5.3 times after punchy Ebitda adjustments.
When the leveraged lending guidance was updated, regulators described loans without full lender protections as “aggressive,” said leverage of more than 6.0 times “raises concerns” and that companies should be able to pay back at least 50% of total debt within five to seven years.
Going forward, agencies will limit the use of numerical definitions or other “bright-lines” in supervisory guidance, according to the statement.
Terms have loosened as leverage increases. More than US$356bn of loans, or about 75% of the leveraged institutional market, in the first half of the year was covenant-lite, according to LPC data, with little to no lender protection.
Lenders will test the limits amid strong investor demand, one banker warned. Issuance of US Collateralized Loan Obligation (CLO) funds, the largest buyers of loans, is forecast to hit a record US$150bn this year.
Regulators have gradually taken a more hands-off approach to the market. The OCC chose not to make leveraged loan underwriting practices a large bank supervision priority in 2018, for the first time in at least three years.
“The agency has observed no changes among OCC-regulated institutions that result in a change to its assessment of the risk to the system from that activity,” an OCC spokesperson said. A Fed spokesperson declined to comment.
The regulators’ September statement may not make a difference because the market is already so aggressive, market participants said. There could be little room for a further increase if leverage is already hitting 7.6 times, a banker said.
As the agencies step back, banks are focusing internally on self-regulation to ensure the safety and soundness of their underwriting process.
“One or another bank may be more aggressive than it has been willing to before, but I don’t view this as lifting a gate and a lot of banks will come barreling in and mud wrestle the non-banks for a huge amount of leveraged lending volume,” said Karen Petrou, a co-founder of consulting firm Federal Financial Analytics. “I just don’t think that’s going to happen.”