On March 22, 2013, U.S. regulators, consisting of the Office of the Controller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Federal Reserve) and the Federal Deposit Insurance Corporation (FDIC and, collectively with the OCC and the Federal Reserve, agencies), issued their final interagency guidance on leveraged lending.
The final guidance updates and replaces existing guidance from 2001 and forms the basis of the agencies' supervisory focus and review of supervised financial institutions. These institutions include national banks, federal savings associations and federal branches and agencies supervised by the OCC; state member banks, bank holding companies, S&L holding companies and all other institutions for which the Federal Reserve is the primary federal supervisor; and state nonmember banks, foreign banks having an insured branch, state savings associations and all other institutions for which the FDIC is the primary federal supervisor. Institutions subject to the final guidance include U.S. branches and agencies of foreign banking organizations. The compliance date for the final guidance is May 21, 2013.
The final guidance outlines, for agency-supervised institutions, high-level principles related to safe-and-sound leveraged lending activities, including underwriting considerations, assessing and documenting enterprise value, risk management expectations for credits awaiting distribution, stress testing expectations, pipeline portfolio management and risk management expectations for exposures held by the institution. Although the final guidance was not adopted as a rule, actions taken by a supervised institution inconsistent with the guidance would, at a minimum, be subject to supervisory criticism.
The final guidance does not provide a bright-line definition of leveraged lending, instead urging supervised institutions to ensure that their policies include criteria to define leveraged lending that are appropriate to the institution. However, the final guidance does provide certain common definitions of leveraged lending, including the following:
- transactions whose proceeds are used for buyouts, acquisitions or capital distributions (e.g., so-called dividend recaps)
- transactions in which the borrower's total debt/EBITDA exceeds 4 to 1 or senior debt/EBITDA exceeds 3 to 1 (in each case measuring debt on a gross basis rather than net of cash on hand)
Importantly, the final guidance does not consider asset-based loans (ABL) to be leveraged loans unless such loans are part of the entire debt structure of a leveraged obligor. In addition, the final guidance does not consider so-called fallen angels (loans that do not meet the definition of leveraged lending at origination, but migrate into that definition at a later date due to changes in the borrower's financial condition) to be leveraged loans, on the basis that a loan should be designated as leveraged only at the time of origination, modification, extension or refinancing. Loans to investment grade borrowers were not categorically excluded in the final guidance from being leveraged loans. The final guidance does, however, indicate that its references to leveraged lending and leveraged loan transactions do not include "bond and high-yield debt."
Some highlights of the final guidance include the following:
- Each institution should establish its own leveraged loan definition and measure based on the institution's business lines, but the EBITDA-based measure of leverage presented in the final guidance1 represents "the supervisory measure that may be used as an important factor to be considered in defining leveraged loans based on each institution's credit products and characteristics." The agencies believe that having a consistent definition for supervisory purposes will help to ensure a consistent application of the guidance.
- As a general guide, base case cash flow projections should show the ability to fully amortize senior secured debt, and repay a significant portion (supervisors commonly assume 50%) of total debt, over the medium term (five to seven years is commonly assumed by supervisors).
- Covenant-lite and PIK-toggle loan structures "may have a place in the overall leveraged lending product set"; however, the agencies will closely review such loans as part of the overall credit evaluation of an institution.
- Institutions looking to rely on sponsor support as a secondary source of repayment for a leveraged loan (e.g., under a guarantee) should be able to provide documentation, including financial or liquidity statements, showing recently documented evidence of the sponsor's willingness and ability to support the credit extension.2
- Generally, a leverage level after planned asset sales (that is, the amount of debt that must be serviced from operating cash flow) in excess of 6 times total debt/EBITDA will raise supervisory concerns for most industries.
- If the primary source of repayment (e.g., operating cash flows) becomes inadequate, the agencies believe that it would generally be inappropriate for an institution to consider enterprise value as a secondary source of repayment unless that value is well supported (evidence of well-supported value may include binding purchase and sale agreements with qualified third parties or thorough asset valuations that fully consider the effect of the borrower's distressed circumstances and potential changes in business and market conditions).
- An institution should develop appropriate policies and procedures relating to potential conflicts of interest, such as when it has both equity and lending positions or when the institution serves as financial advisor to the seller and simultaneously offers financing to multiple buyers (that is, stapled financing).3
Importantly, the final guidance omits reference to financial institutions having fiduciary responsibilities to loan participants when underwriting and syndicating leveraged loans. The earlier proposed version of the guidance had asserted the existence of such a duty, but in the final guidance, the agencies agree with industry comments that no such duty exists.
1. This is a cash flow measure, in contrast to, for example, total debt to tangible net worth, which is a balance sheet measure of leverage used by some smaller banks.
2. This represents a softening of the position in the earlier proposed version of the leveraged lending guidance, which would have imposed sponsor diligence and reporting obligations even where (as is the case in many LBOs) the sponsor is not being relied upon as a secondary source of repayment.
3. The long-standing practice of stapled financing has recently been criticized in court cases, including by the Delaware Court of Chancery in a 2011 stockholders' derivative lawsuit associated with the proposed LBO of Del Monte Corporation. More recently, in connection with the proposed Dell LBO, press reports have indicated that at least one major financial institution has declined to offer stapled financing following such criticism. See "Dell Deal Done Differently – J.P. Morgan Doesn't Try 'Staple Financing' After Court Criticized the Practice," Wall Street Journal, January 24, 2013.
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