NEW YORK, Nov 2 (LPC) - Banks are shrugging off regulators’ increasingly strident warnings about frothiness in credit markets and continuing to churn out highly leveraged loans as private equity firms push for aggressive buyout deals.
Regulators including Federal Reserve (Fed) Chairman Jerome Powell, his predecessor Janet Yellen, and the Bank of England have been increasingly vocal in the last two months about loosening standards in the leveraged loan market.
But bankers are paying their warnings little heed and are continuing to produce highly leveraged loans after the consequences for exceeding existing US leveraged lending guidance were eased earlier this year.
This is allowing deals to reach the market that would not have previously passed regulatory scrutiny with leverage of more than 6.0 times and limited ability to repay debt, as banks compete for business.
“There is a feeling that more firms are pushing [the guidance boundaries] and some highly regulated firms feel competitive pressure,” said Christina Padgett, a senior vice president at Moody’s Investors Service, who said that loan terms are much more aggressive than during the pre-crisis buyout boom.
Banks are complaining that regulators are being hypocritical by criticizing the market, but at the same time allowing lenders to proceed with little clarity over potential consequences or even penalties.
“It feels like a populist knee jerk reaction to something they (regulators) don’t really understand. No-one’s going to get fired for saying there’s too many leveraged loans or standards are too weak,” a senior loan banker said.
The next big test for the US market will be the Shared National Credit (SNC) review, which is expected to be released in December, and assesses credit risk and trends as well as risk management practices. The assessment will reflect data as of June 30, before regulators started to sound the alarm about the asset class.
Before the guidance was eased in September, banks had to pay close heed to the SNC review and explain any loans that were ‘criticized.’
In last year’s SNC review, regulators said that agent banks had improved their underwriting and risk management processes to reduce and manage the risk of their leveraged lending exposure since 2013.
But they noted that US$317bn of leveraged credit was in the agent banks’ lowest pass rating category, raising supervisory concerns.
Although some market players feel that an unshackled market could be heading towards the abyss once again, others feel that the market will become self-regulating as banks rein in excesses to avoid stoking credit losses and being hung with overly aggressive deals if the market turns.
"Frankly, rising rates and the inevitable turn in the credit cycle will be much more effective in tamping down risk than any banking regulator acting as some sort of ‘super credit committee,'" said Richard Farley, chair of the leveraged finance group at law firm Kramer Levin.
Looser guidance is expected to produce more jumbo highly leveraged loans as cash-rich private equity firms eye public to private deals and corporate carveouts, and investor demand shows no signs of slowing as floating-rate debt retains its sparkle in a rising interest rate environment.
Private equity funds were sitting on US$1.1trn of dry powder in October, according to Preqin, and though buyout activity was lower in the third quarter than the previous three months, more than 1,200 deals were completed.
That pushed deal value in the first nine months of 2018 to about 91% of the full-year 2017 total, according to the data provider’s quarterly private equity and venture capital update. Private equity firms are paying high multiples, however, which is reflected in loan multiples and aggressive terms and conditions.
Debt compared with Ebitda, which measures leverage, increased to 6.94 times in the third quarter, the highest level since the same period in 2014, according to LPC data. Quarterly leverage peaked at 7.4 times in the second quarter of 2007.
Leverage for KKR’s buyout of Envision Healthcare Corp was about 7.2 times, Moody’s said in September, though it expects it to drop to the low 6.0 range during the next 12 to 18 months.
“It is much more extreme than 2007; covenant-lite is more prevalent and structures are worse. The refrain about being concerned about covenants is not abating,” Padgett said.
About 73% of the leveraged institutional market in the first nine months of 2018 was covenant-lite, LPC data shows. Looser guidance and more flexible deal structures are giving private equity firms ever more license to manage companies and is also likely to hit recovery rates going forward as lenders will have little warning of trouble.
“Part of the concern is that flexibility is in [the documents] from day one,” said Jessica Reiss, head of leveraged loan research at Covenant Review. “When things do turn, management is going to take advantage of that flexibility they have been given to give themselves more runway, or from a private equity standpoint, pay themselves a dividend to get a return on their investment.”
Moody’s is predicting that first-lien term loan recoveries will be 61% going forward versus the 77% long-term historical average. (Reporting by Kristen Haunss. Additional reporting by Tessa Walsh Editing by Jon Methven)