ECB lending guidelines could drive riskier LBOs underground

LONDON: Proposed leveraged lending guidelines from the European Central Bank could force riskier lending into unregulated channels and create unintended opportunities for arbitrage as well as breed market distortion.

In an attempt to curb banks from underwriting riskier LBOs, the European banking watchdog has put forward a red line of 6x leverage in its draft guidance on "leveraged transactions", closely mirroring guidelines introduced by US regulators in 2013.

Fears are growing, however, that Europe could see similar unintended consequences to the US, where the introduction of the threshold has driven highly leveraged lending underground.

"It's a bit of a game of whack-a-mole, because not only will the non-bank lenders step into the breach and provide larger and larger loans, but what we've seen happen in the US is that the banks have actually stepped up their lending to these private credit institutions," said Luke McDougall, a leveraged finance partner at Paul Hastings.

US private credit and direct lending funds once specialised in mid-market buyouts. However, they have raised enough firepower in recent years to supplant the institutional high-yield bond and leveraged loan packages typically required for large-cap deals, such as Thoma Bravo's US$3bn take-private acquisition of data analytics firm Qlik Technologies in June.

UNREGULATED CHANNELS

A senior manager at a London-based credit fund that specialises in direct lending said the ECB's proposed rules would only hasten the debt market's shift into "unregulated channels".

"It makes no difference to us whether a deal is publicly syndicated or not, but if I was on the cap markets desk at a bank, I'd be worried," he said. "You're only going to see more and more self-syndicated deals."

Private equity firms in the US are already cutting out banks to syndicate LBO debt themselves, a phenomenon KKR spearheaded on its Mills Fleet Farm buyout at the end of 2015.

One leveraged finance banker said that direct lending funds are already targeting more highly leveraged transactions than banks, irrespective of the ECB's new regulation, however.

"The return hurdles these guys originally set are getting harder and harder to achieve - the only way they can do it is pushing the needle on leverage," he said.

And a second banker said he thought that concerns around leverage were "neither here nor there", as there is "no regulation on any terms" in the direct lending market.

"There is a broader concern that those kinds of products are underpricing illiquidity, so it'll be interesting to see how they perform over the course of the credit cycle," he added.

"They're going very well in terms of raising money and building assets right now, but when you've lent 8x levered money to a small business and the credit cycle starts to turn, you could see those liquidity issues come to the fore."

AGGRESSIVE ADJUSTMENTS

Another concern is that guidelines will create scope for regulatory arbitrage, with lenders willing to provide more aggressive terms elsewhere to compensate for lower leverage.

The US has seen some banks make larger and larger adjustments to companies' earnings in order to comply with the 6x leverage threshold, rather than eschewing riskier deals.

The Federal Reserve last month reprimanded underwriters of mixed martial arts franchise the UFC's LBO, according to press reports, for making large add-backs to Ebitda to comply with the guidance.

"We're getting to the point now where the definition of Ebitda is going to have to be regulated," said one high-yield portfolio manager.

"I have no doubt this resulted from the regulation on leverage; the quid pro quo has been more aggressive use of documentation."

The ECB has already looked to head off some of the abuses seen in the US, explicitly stating in its draft that its leverage thresholds are based on "unadjusted Ebitda".

But private equity firms, no longer able to leverage companies as high as they would like to initially, can simply pressure underwriters to give them greater flexibility to do so in future.

"The sponsor-friendly movements we've seen in Ebitda adjustments are not primarily on out-of-the-box leverage, as that tends to be heavily diligenced, but more on aggressive pro forma allowances around future actions," said McDougall.

"Sponsors are also pushing for looser and looser debt incurrence covenants, meaning a deal could be compliant on day one but have headroom to lever up on day two."

Trying to grapple with these minutiae of leveraged finance documentation could create even more headaches for the ECB.