Has leverage reached its limits?
In a record year for US M&A, one traditional source of deal financing, leveraged lending for private equity firms, is under pressure. In 2015, leveraged loans by banks—traditionally, a key source of funding for private equity firms undertaking deals—were down 32 percent from a year earlier, according to Debtwire. By contrast, between 2009 and 2013, US leveraged loan volumes surged nearly threefold, reflecting vibrant post-crisis activity by private equity firms.
“In 2015, competition from cash-rich corporates, high valuations and pressure on leveraged lending from US regulatory authorities combined to drive PE firms’ share of US M&A volume to its lowest level since 2009,” says Eric Leicht, partner at White & Case. According to Mergermarket data, PE buyouts as a percentage of US M&A was at 18.2 percent in 2015, the lowest level since falling to 16.6 percent in 2009.
The question is whether—or to what degree—the relative decline in private equity’s role in M&A is due to limits placed on banks via the leveraged lending guidelines that were issued in 2013.
Although many factors were at play, we believe that the guidelines prevented many PE firms from obtaining loans at the leverage levels needed to compete for some of the larger deals in 2015, particularly given soaring valuations. As banks complied with the guidelines, PE firms were taken out of the running.
Banks on the retreat In 2013, the US Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) published updated guidance to financial institutions involved in leveraged lending.
In their guidance, the agencies flagged their concerns that some banks’ lending policies were becoming too risky. While noting that leveraged lending had declined during the crisis, they commented that “volumes have since increased, and prudent underwriting practices have deteriorated.”
The agencies avoided setting dollar limits for banks’ loan books. Instead, they warned that any bank lending more than six times EBITDA, offering non-amortizing loans or loans with poor covenant protection, or creating deals that rely on intangible assets for repayment could merit intensive scrutiny.
The guidance took some time to bite, but by 2014 a number of banks had received letters from regulators demanding “immediate attention” to their leveraged loan portfolios, causing some proposed deals to be put on ice. In November 2014, the agencies provided clarification of the criteria to be used when assessing compliance with the guidelines in the form of an “FAQ” addressed to market participants.
In November 2015, the Federal Reserve noted that, while banks had made progress in meeting the 2013 guidance, it still observed gaps between industry practices and those that regulators consider safe and sound.
In particular, the central bank pointed out a sharp rise in substandard, doubtful or loss-making loans to the oil & gas sector, from 3.6 percent of total classified commitments in 2014 to 15 percent in 2015. The Federal Reserve’s recent comments offer little comfort for anyone hoping for a softening in regulators’ approach.
Non-banks lend a helping hand However, not all lenders are constrained by the rules. Three categories of institution typically provide leveraged finance to support US M&A activity: □ Regulated banks
□ Non-regulated financial institutions (non-banks, such as securities companies, that offer leveraged loans) and
□ Alternative capital providers (hedge funds, asset managers and private equity funds). Of these three types of lender, only the first—regulated banks—is covered by the guidelines. Due to the guidelines, these banks have sometimes been unable or unwilling to participate in financing deals where debt exceeds six times EBITDA. This puts practical limitations on financing acquisitions as deal sizes grow, because big banks are important for the execution of large deals—primarily because of their larger balance sheets and sophisticated distribution platforms.
Unsurprisingly, non-regulated institutions and alternative capital providers are now taking up some of the slack in the leveraged lending market. Recent statistics indicate that many non-regulated financial institutions, such as Jefferies LLC, Nomura and Macquarie Group, grew their US loan businesses significantly since 2013. Figures from Thomson Reuters show that players in this category took a 22 percent share of lending to support US leveraged buyouts in the first three quarters of 2015, double the levels of a year earlier.
The availability of financing from alternative capital providers is likely to depend on the size of the deal. “If you want to raise more than a billion dollars of debt, you will likely still have to include at least one of the big money center banks that has the distribution power to syndicate a deal,” says Jake Mincemoyer, partner at White & Case.
At the lower end of the size scale, the motivations and capacity of a leveraged lender may be quite different. “If you need only a couple of hundred million dollars of debt to finance a deal, a private investment fund that buys and holds debt may step in because they have the resources to handle that level of commitment,” adds Mincemoyer.
Across the market, non-regulated institutions and alternative financers now seem to have a substantial new opportunity.
For example, in November, Golub Capital joined Barclays, Morgan Stanley and Macquarie in arranging a US$1.6 billion facility for the US$2.7 billion buyout of healthcare analytics provider MedAssets. It was the largest deal the alternative lender has been involved with to date. Unlike underwriting Wall Street banks, Golub and its competitors have a large appetite for holding loans as well as syndicating them with investors.
“Some of the alternative capital providers now have big aspirations to build out their distribution side,” comments White & Case’s Leicht. “They want to be able to market a credit and then combine a possible buy-and-hold strategy with the ability to syndicate deals, along the lines of the traditional investment banking model.”
High prices have been an important factor for buyout firms reviewing their deal financing options. Valuations reached near record levels in 2015, rising to an average of 16.5 times EBITDA in the United States during the first half of the year, according to Intralink’s Deal Flow Predictor. By comparison, in deals involving private equity firms as buyers, valuations have averaged 10 times EBITDA, according to Standard & Poor’s. It would seem that stockpiles of corporate cash and high valuations of stock used as currency for many of these trades have managed to push private equity to the sidelines when it comes to the bigger deals.
“It’s not just the guidelines that have been affecting private equity firms’ overall levels of M&A,” says Mincemoyer. “When a firm looks at a potential acquisition, it needs to find not just a strategic fit from a business perspective, but also an acceptable internal rate of return (IRR). Valuations in some sectors are getting tougher from the point of view of IRR expectations.”
However, irrespective of high valuations and the recent decline in M&A market share, the leveraged finance market is likely to continue to evolve. While banks still have a dominant role in larger deals, the competitive advantage for non-banks with the infrastructure to syndicate and distribute loans is increasing, particularly in medium-sized deals. And there will be a more prominent role for alternative capital providers in financing smaller leveraged loans.
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Leveraged lending guidelines have contributed to the relative decline in private equity M&A in the United States