European Central Bank publishes final guidance on leveraged transactions
On 16 May 2017, the European Central Bank ("ECB") published its final guidance on leveraged transactions together with its responses to the public consultation on the draft guidance (together the "Guidance"). The Guidance summarises the key supervisory expectations concerning leveraged transactions.
Background
The high liquidity and ensuing hunt for yield in recent years have warranted specific monitoring of credit quality and closer supervisory scrutiny of leveraged transactions by the ECB. The 2015 ECB survey has shown significant variations across credit institutions as regards definitions of leveraged transactions, risk management and reporting frameworks. Further, the ECB considers that loan documentation risks may be exacerbated by the prevailing borrower-friendly market.
The ECB intends to establish and harmonise industry best practices regarding risk management and reporting requirements applied to leveraged transactions.
Ultimately, the goal of the ECB is to strengthen credit institutions’ ability to operate during any economic downturn and to facilitate lending to leveraged borrowers throughout the entire business cycle – in other words, to avoid a credit crunch.
The final Guidance (and the accompanying feedback statement) has clarified and amended several topics compared to the 2016 draft, inter alia comprising the following changes:
- Adjustments to EBITDA are permitted, if duly justified and independently reviewed;
- Exclusion of loans to (i) investment-grade rated borrowers, (ii) small and medium-sized enterprises (SMEs) unless owned by one or more financial sponsors and (iii) public sector and financial sector entities; and
- Inclusion of shareholder loans, other subordinated debt and PIK debt in the Total Debt.
US Guidance
The Guidance is similar to the US Guidance on Leveraged Lending issued by the US federal bank regulatory agencies in March 2013 ("US Guidance"), but differs on a number of details. The differences are set out in the table attached to this note.
It seems reasonable to expect that the Guidance is likely to have similar effects on the European market as the introduction of the US Guidance had on the US market.
Soft - but compulsive? - policing
The Guidance is not binding. However, the ECB expects that all significant institutions will translate the Guidance into internal policies and procedures, proportionally to the size and the risk profile of their leveraged transactions relative to their assets, earnings and capital. Lenders are encouraged to apply these principles to other relevant types of transactions, too.
Consequently, implementation of the Guidance will be part of the ECB's day-to-day supervisory dialogue and will be enforced through the ongoing supervision by Joint Supervisory Teams (JSTs), as well as dedicated on-site inspections. It will also be taken into account in the Supervisory Review and Evaluation Process. Following the implementation phase, in which JSTs will monitor the implementation, a combination of off-site investigations and more comprehensive on-site investigations will be applied, accompanied by specific recommendations as to the assessment of credit files.
Additionally, selected institutions may be asked to regularly report on their leveraged transaction exposure, its development and associated risk.
Finally, it is not inconceivable that the Guidance may spill over into other policing fields, e.g. the fit and proper assessment for new directors of credit institutions (for which new guidelines have been issued concurrently on 15 May 2017, seeking to harmonise supervisory practice).
Scope
Affected Institutions
The Guidance applies to all significant credit institutions supervised by the ECB under Article 6(4) of Council Regulation (EU) No 1024/2013 (SSM Regulation). Whether a credit institution is "significant" depends on a number of criteria, including its size, importance for the economy and cross-border activities. Institutions incorporated outside the territorial scope of the Single Supervisory Mechanism (SSM), e.g. US or UK lenders, are not subject to ECB supervision; however, any branch established within the confines of the SSM will be supervised by the ECB.
Affected Transactions
The Guidance applies to all types of loan or credit exposure that meet at least one of the following conditions:
- the borrower’s post-financing level of leverage exceeds a Total Debt to EBITDA ratio of 4.01; and/or
- the borrower is owned (> 50%) or controlled by one or more financial sponsors2.
However, certain loan types are carved out from leveraged transactions:
- loans to natural persons, credit institutions, investment firms, public sector entities and financial sector entities;
- loans where the consolidated exposure of the credit institution is below EUR 5,000,000;
- loans to SMEs, except if they are owned by one or more financial sponsors;
- loans classified as specialised lending (as defined in Article 147(8) of the CRR), comprising project finance, real estate, object financing and commodities financing;
- trade finance; and
- loans to borrowers with an investment-grade rating (internal or external).
To ensure that no undue exclusion has been made, the scope and implementation of the "leveraged transaction" definition by an institution should be regularly reviewed by appropriate independent audits.
The Guidance is limited to loans and does not cover capital market transactions (including bonds). Note that such debt would still increase Total Debt – and thus leverage – for purposes of the Guidance.
Total Debt: gross debt capacity
"Total Debt" comprises a borrower's entire debt capacity. Thus, Total Debt should be calculated not only as the drawn debt but on the basis of both total committed debt (including drawn and undrawn debt) and any additional debt that loan agreements may permit (e.g., incremental, additional or accordion facilities as well as other permitted third-party financings). This reflects that the ECB is concerned about downturn and crisis scenarios, in which case commitments and other permitted debt capacity tend to be fully utilised.
Total Debt is to be calculated on a "gross" basis, i.e. without netting cash against debt. Netting would entail supervisory concerns, as cash is typically scarce in a crisis scenario.
Finally, lenders should note that shareholder loans, other subordinated debt and PIK debt – whether payable in cash or in additional debt or equity – will be part of Total Debt (and thus increase leverage). Institutions may wish to bear this in mind when structuring warrants and other hybrid instruments.
EBITDA: limited adjustments
On a preliminary basis, the ECB has now permitted adjustments to EBITDA, provided that they are duly justified and reviewed independently of the front office. The ECB appears to be cautious whether adjustments with respect to pro forma "future synergies", "future earnings" or "run-rate EBITDA" would regularly meet that test. As part of its ongoing review of the Guidance and its effects, the ECB may decide to revisit the definition of EBITDA and the permissibility of adjustments to EBITDA.
Key aspects
The main part of the Guidance focuses on several inter-locking aspects. Generally, institutions should:
- define acceptable leverage levels; transactions presenting high levels of leverage – i.e. Total Debt3 exceeding 6.0 times EBITDA – should remain exceptional, should be duly justified and should be part of the institution's risk management escalation framework4;
- define their appetite and strategy for leveraged transactions across the various business units as well as across the loan lifecycle (origination, syndication, secondary trading);
- ensure that each business function adheres to the defined appetite and strategy for leveraged transactions;
ensure prior independent review and approval of all proposed transaction steps; and
- implement on-going monitoring of the portfolio of leveraged transactions.
Risk appetite and governance
A sound governance structure should be implemented for all leveraged transactions originated, syndicated or purchased by a credit institution. Proposed minimum requirements are:
- Comprehensive overview of all leveraged transactions by both senior and risk management;
- Prior and independent risk management review and approval of all leveraged transactions risks; and
- Dedicated procedures to prevent conflicts of interest, ensure adherence with regulatory requirements regarding market conduct, ensure confidentiality of private or privileged information (including Chinese walls, e.g. to separate origination from secondary trading) and to avoid reputational risk.
Underwriting and syndication
Credit institutions should conduct a detailed analysis, including the following:
- assessing the syndication and pricing risk, with independent and prior approval / verification;
- regular monitoring and reporting of all pending syndications, as well as independent review;
- monitor and target appropriately diverse investor categories to minimise syndication risk5;
- develop a stress-testing framework to assess the effect of market risks and disruptions; and
- identify "hung transactions" (not syndicated within 90 days of closing), and establish a framework as to holding strategy, accounting, regulatory classification (including re-classification from the trading book to the banking book) and capital requirements calculation.
Credit approval
Credit approval should be required for a new transaction as well as a material modification, renewal or a refinancing. It should be preceded by both a due diligence by origination as well as a critical review by independent risk management. The analysis should include (in addition to the obvious items):
- the borrower's ability to cover debt service by cash-flow generation;
- the borrower's ability to repay a significant share of its debt or de-lever to a sustainable level within a reasonable time frame6;
- the bank base case and stress case should be sufficiently conservative and capture tail-end market events over the lifetime of the loan;
an enterprise valuation of the borrower; and - flagging weak covenants: covenant-free, covenant-lite or significant headroom.
Ongoing monitoring
A regular on-going monitoring of the leveraged loan portfolio, an annual review of "hold book" exposures and more frequent reviews for deteriorated exposures (low ratings, high leverage, watch-listed, forborne performing and non-performing, defaulted) should be implemented. Credit institutions need to ensure that their internal criteria are fully aligned with all relevant regulatory, legal and accounting requirements.
Monitoring of credit exposures should include:
- Debt repayment capacity (including generation of stable and sufficient cash flows);
- signs of impairment, default or unlikeliness to pay, such as a material financial covenant breach or non-remediation of a covenant breach; and
- a stress-testing framework that captures tail-end market events such as a surge in default rates, rating migrations or collateral discounts.
At least every three years, each credit institution's internal audit function should perform a regular review of leveraged transactions and of the compliance with the Guidance as part of its audit cycle.
Reporting requirements and Management Information Systems (MIS)
A dedicated management information system (MIS) should provide regular reports to senior management about:
- key markets trends in leveraged finance;
- the leveraged loan book across all business units and geographies, including the deal pipeline, the "hold book" and secondary market transactions;
compliance with internal limits and results of stress tests; - potential concentrations in terms of facility type, geography, sector or individual credits and an overview of the quality and profitability of transactions; and
- exposures to weak covenant features and potential material breaches of covenants.
The MIS should be sufficiently granular to enable identification, aggregation and monitoring of leveraged transactions and capture all the relevant aspects of the Guidance.
Conclusion
Effects on market
A common concern is that the Guidance may accelerate the growth of unregulated funding channels. In particular, market participants (such as private debt funds) which are exempt from the Guidance and/or bank-focused supervisory rules may be able to gain a greater market share in the leveraged finance markets. Arguably, there may already be a trend for banks to favour short-term working capital funding with the long-term funding moving to the capital markets and/or shadow-banking sector. The Guidance might also give rise to a regulatory arbitrage, with lenders willing to provide more aggressive terms elsewhere to compensate for lower leverage.
The ECB seems to consider the growth of leveraged financing in the "shadow banking" market not to be an aberration but a chance of smooth financing across the business cycle, especially if the "shadow banks" take on significantly more risk in a certain industry than the regulated credit institutions.
Effects on loan documentation
Effects on loan origination and loan documentation may vary, but might comprise the following:
- More stringent due diligence and credit risk assessment;
- Increased reporting obligations of borrowers, in particular to permit on-going monitoring of Total Debt (gross) and permitted financial indebtedness;
- Inclusion of undrawn commitments and uncommitted facilities (e.g. acquisition or capex facilities) in Total Debt (gross) may curb banks' appetite for such facilities;
- Increased tendency to favour amortising facilities (TLA) over bullet repayments (TLB);
- Effects on capital structure: The inclusion of shareholder loans, subordinated debt and PIK debt in the definition of Total Debt might make these kinds of financing less attractive;
- EBITDA adjustments may need further justification to be included in the loan documentation; and
- Conceivably, financial covenants might be revised to include total gross debt / gross leverage.
Outlook
We recommend that all significant credit institutions review, and if necessary revise, their internal procedures to ensure that they comply with the Guidance when it takes effect on 16 November 2017.
They should also note that they will need to draw up and submit an internal audit report to their JST as of November 2018, detailing how the expectations expressed in the Guidance have been implemented, and should expect heightened scrutiny of the ECB in the run-up to this deadline.
Should you have any questions, please feel free to contact us at any time.
1 Calculated at the consolidated borrower level, unless affiliate support in case of financial difficulties cannot be assumed.
2 Financial Sponsor means any investment firm that makes private equity investments in and/or leveraged buyouts of companies with the intention of a medium term exit.
3 Please recall that this is Total "gross" Debt, and that the resulting gross leverage threshold of 6.0x may well be equivalent to a substantially lower net leverage as customarily used for loan agreements. Generally, the leverage ratio of 6.0x applies irrespective of the relevant industry.
4 We note that the ECB seems to have dropped its requirement that such transactions be referred to the "highest" level of a credit committee.
5 Note that this might require a review of the business model of specialised lenders.
6 Either fully amortise senior secured debt or repay at least 50% of Total Debt over a period of five to seven years.
Comparison of US Guidance vs. ECB Guidance
| Key Component | US Guidance | ECB Guidance |
| Instiutions covered: |
The US Guidance applies to any banking organization regulated by the Federal Reserve Board, the Federal Deposit Insurance Corporation or the Office of the Comptroller of the Currency (collectively, the "US Agencies"), which as a general rule include the following:
Where the leveraged loan is booked is irrelevant as the US Guidance applies to leveraged lending activities both within and outside of the US. The US Guidance would not apply to non-banks and other alternative credit providers that do not fit within the above. |
The ECB Guidance applies to all "significant credit institutions" supervised by the ECB under the SSM. Eurozone countries are automatically included in the SSM and other EU countries can choose to participate. As the UK does not participate in the SSM, credit institutions established in the UK are not supervised by the ECB. A credit institution is only caught in the guidance if it is a credit institution which takes deposits or other repayable funds from the public and grants credit from its own account. The ECB Guidance does not cover non-banks and other alternative credit providers that do not fit within the above. In contrast to the US Guidance, implementation will be subject to principle of proportionality, by reference to the size and risk profile of an institution's leveraged transactions relative to its assets, earnings and capital. The US does not expressly provide for any kind of proportionality principle. |
| Definition of "leveraged transactions": |
Banks are expected to develop an institution-wide definition specific to that institution. The US Guidance does not specify what should be included in the definition but, instead, identifies four characteristics that, either separately or in combination, are common to leveraged lending transactions: (i) proceeds from the loan are used for buyouts, acquisitions, or capital distributions; (ii) loans resulting in Total Debt/EBITDA exceeding 4x or in Senior Debt/EBITDA exceeding 3x; (iii) the borrower is recognized in the debt markets as a highly leveraged firm, which is characterized by a high debt-to-net-worth ratio; or (iv) loans resulting in financing leverage, as measured by its leverage ratios (including debt-to-assets, debt-to-net-worth, debt-to-cash flow, or other similar standards common to particular industries or sectors), significantly exceeds industry norms or historical levels. |
Institutions are expected to develop and implement a comprehensive, institution-specific internal definition of leveraged lending. In contrast to the US, the ECB Guidance provides that the definition should include all types of loan or credit exposure that meet one of following two conditions: (i) the borrower's post-financing leverage exceeds a Total Debt to EBITDA ratio of 4x; or (ii) the borrower is owned (>50%) or controlled by one or more financial sponsors. |
| Transactions covered: |
All types of leveraged lending exposures, including:
but specifically excluding:
|
All types of leveraged lending exposures, including:
but specifically excluding:
|
| Total Debt to EBITDA greater than 6x: | While this is not a bright line test for determining whether the transaction falls within the US Guidance, the US Agencies have noted that excessive levels of leverage do raise supervisory concerns and loans that exceed this leverage level may receive additional scrutiny. | The ECB Guidance takes a similar approach and the ECB expects credit institutions to ensure that more stringent risk management practices are put in place for transactions where total debt is in excess of 6x EBITDA. |
| Definition of EBITDA: |
The US Guidance does not include a definition but the US Agencies have noted that:
|
Similar to the US, the ECB Guidance does not include an EBITDA definition but notes that any adjustments that enhance EBITDA should be duly justified and reviewed by a function independent from the front office function. |
| Definition of Total Debt: | The US Guidance requires the use of a gross measure, specifically providing that cash should not be netted against debt for purposes of calculating total debt. | The ECB Guidance takes a similar approach to the US. |
| Repayment: | The US Guidance also notes the importance of the borrower's ability to amortize at least 50% of its total debt over 5 to 7 years. However, these de-levering guidelines may be offset where the borrower possesses other compensating means of financial support (including accessibility to quality liquid assets and financial sponsor support). | The ECB Guidance takes a similar approach to the US Guidance, but notes that adequate repayment capacity is defined as the ability of the leveraged borrower to fully amortise the senior secured debt or repay at least 50% of total debt over a period of five to seven years. |
| Underwriting Standards: | Financial institutions should have clear, written and measurable underwriting standards that set clear underwriting limits regarding leveraged transactions, including the size that the institution will arrange both individually and in the aggregate for distribution. |
Similar to the US, credit institutions should define standards and set an underwriting limit and sub-limits detailing both size and the nature of transactions that a credit institution is permitted to participate in. |
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