(Corrects time period in 24th para.)
By Jonathan Schwarzberg
NEW YORK, Oct 19 (LPC) - Leverage ratios on private equity-backed deals are rising again as banks compete more aggressively for lucrative private equity loans after regulators relaxed leveraged lending guidelines earlier this year.
The guidelines were put in place in 2013 to limit systemic risk and prevent a re-run of the financial crisis, but were relaxed in February and further emphasized in September, by the Republican administration.
In the first nine months of 2018, the guidelines’ original limit of 6.0 times leverage was exceeded by a record 73.1% of private equity buyout loans, up from 64.2% in 2017. This exceeds the previous peak of the market in 2007 immediately before the financial crisis, when 61.5% of deals were levered at that level, according to LPC data.
“The shackles have been taken off,” a banker said.
Strong investor demand for floating rate leveraged loans is exceeding a limited supply of deals as cash continues to pour into the asset class in a rising interest rate environment. Toppy equity markets mean that private equity firms are paying high enterprise valuations, which is producing more highly leveraged loans as banks compete for mandates.
The most aggressive highly leveraged deals are also setting new records with 41.4% of sponsored deals carrying leverage of more than 7.0 times. This eclipses the market’s previous high in 2007, when 38.5% of deals reached that level.
Credit Suisse is currently in market with US$372m of incremental term loan debt backing a dividend for enterprise software company Hyland Software’s private equity firm Thoma Bravo, which will put adjusted leverage at 7.5 times, according to Moody’s Investors Service.
“Most of the time banks are now underwriting to market-clearing levels now as opposed to regulatory levels,” the banker said.
The Federal Reserve, however, expressed concern over the changes in the US$1.1trn US leveraged loan market in September.
“Some participants commented about the continued growth in leveraged loans, the loosening of terms and standards on these loans, or the growth of this activity in the non-bank sector as reasons to remain mindful of vulnerabilities and possible risks to financial stability,” according to the minutes of the policy meeting.
When the guidelines came into effect in 2013, deals with debt-to-Ebitda leverage ratios of more than 6.0 times received unwelcome extra scrutiny from regulators including the Office of the Comptroller of the Currency, the Federal Reserve and the Federal Deposit Insurance Corp.
Regulated banks were instructed to make sure that all the company’s secured debt, or half of total debt, could be paid down within five to seven years and explain any exceptions on ‘criticized’ deals.
This immediately handed a competitive advantage to institutions not subject to the guidelines, which were able to lead more highly leveraged loans than regulated banks.
That edge disappeared in September, when the Fed and the OCC said the guidelines are not technically rules, following February’s comments by Comptroller of the Currency Joseph Otting that banks could underwrite outside the guidelines as long as they did so prudently and had capital to support it.
Relaxing the guidelines has given banks that were previously worried about attracting adverse attention, or even penalities from regulators a free hand to underwrite loans with leverage of more than 6.0 times.
Regulated banks are, however, emphasizing that they are still underwriting responsibly and without the loose criteria that preceded the credit crisis in 2008, bankers said.
“Our bank is really underwriting the same way,” the banker said. “But we don’t feel like we have to worry about the regulators cracking down if we do a deal with too much leverage.”
The US$5.45bn term loan backing the buyout of Envision Healthcare had leverage of 7.2 times, according to Moody’s Investors Service, but was marketed at less than 7.0 times with Ebitda adjustments, sources said.
The deal was underwritten by regulated banks including Credit Suisse, Citigroup, Morgan Stanley, Barclays, Goldman Sachs, UBS, Royal Bank of Canada, Societe Generale, HSBC, Mizuho, BMO, SunTrust and Credit Agricole, and alternative lenders including Jefferies and KKR Capital Markets.
Despite a more level playing field, regulated banks are not yet eroding the market advantage established by lenders including Jefferies and Macquarie, which were not subject to the guidelines in the last few years.
Jefferies was one of the main beneficiaries of the lack of regulation and has held steady this year. In the first three quarters of 2018, Jefferies was 12th in US leverage lending according to the LPC league table, in the same place as a year earlier.
Macquarie has risen to 19th in US leveraged lending for the year to date from 25th in 2017. Nomura has also increased its position in 2018, moving up to 25th from 28th in leveraged lending.
“There have always been one or two banks willing to cross over the (LLG) line. Now there are just more banks on every deal,” said a banker from a firm not subject to the guidelines.
Firms that do not have to comply with the guidelines are expected to continue to underwrite highly leveraged loans, which will force regulated banks to remain competitive as alternative lenders continue to snap at their heels.
Jefferies is leading a US$740m buyout deal for agricultural processing equipment maker CPM Holdings with adjusted leverage of 6.7 times, according to Moody’s Investors Service. The deal backs American Securities LLC’s purchase of the company from Gilbert Global Equity Partners.
“I’m seeing these lenders and many direct lenders on just about every deal,” a leveraged finance lawyer said. “These folks now have an enormous impact on the industry, and they aren’t going away because the federal government is loosening restrictions.” (Reporting by Jonathan Schwarzberg Editing by Tessa Walsh and Jon Methven)