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.
Leveraged lending guidelines have contributed to the relative decline in private equity M&A in the United States