United States: Leveraged Loan Regulatory Uncertainty Presents Opportunities For Direct Loan Funds

Keywords: leveraged loans, regulation, direct loans,

The appetite of institutional investors for yield continues in the current low interest rate environment and has created renewed interest in increasing allocations to fixed income portfolios, including additional allocations to private debt.1 As a result of the heightened regulatory focus on banks and emphasis on enhanced underwriting standards for leveraged loans, investor interest has created an opportunity for non-bank institutions to provide investment opportunities to such institutional investors. Similarly, the gradual disintermediation of banking and exit from higher risk areas of lending has created opportunities for various non-bank institutions to increase their market share in respect of highly leveraged loans.

Non-bank financial institutions such as Jefferies have increased their focus on leveraged loans.2 Fund sponsors have sought to capitalize upon this opportunity through investments in private loans (either themselves making direct loans or acquiring existing loans of private companies). As of July 2015, $46 billion has been raised by funds investing in private debt, which is on track to surpass the 2014 total of $69 billion,3 and senior loan structures have raised more than $32 billion in 2014 and $16 billion through August 2015.4

Background—Leveraged Lending Guidelines

As part of an ongoing effort to regulate financial institutions, the Office of Comptroller of the Currency (the "OCC"), the Federal Deposit Insurance Corporation (the FDIC) and the Board of Governors of the Federal Reserve (the "Fed") have issued guidance to such financial institutions in respect of underwriting and risk management standards. The guidance has evolved since 20135 and has been aimed at achieving of a number of goals relating to systemic risk. These goals include: (i) requiring institutions to create an internal definition of "leveraged lending" that is consistent across business lines; (ii) more uniform credit and concentration policies with limits consistent with risks; (iii) well-defined underwriting standards that include a review of the capacity to de-lever; (iv) appropriately sound methodologies for determining "enterprise value;" (v) sound practices for monitoring of exposures across business lines and pipeline management policies; (vi) setting guidelines for periodic stress testing; (vii) reliance on internal risk-ratings; and (viii) criteria for evaluating financial sponsors (including willingness/ability to repay). However, the guidance has not completely alleviated the need for additional clarity related to the lending practices of financial institutions.

In particular, the initial 2013 guidance, while applying to leveraged loans, did not itself define the criteria of what constitutes a "leveraged loan." In theory, each institution would adopt an appropriate definition and criteria to define such loans consistently across its portfolio; however, the lack of specific criteria in the guidance led to significant uncertainty by institutions as to what types of loans would be subject to scrutiny. The guidance did specify certain "common characteristics" that the regulators regard as indicia of leveraged loans, which included : (i) purpose or use for buyouts, acquisitions or capital distributions; (ii) total debt to EBITDA ratios of greater than 4:1 (the Total Debt Test) or senior debt to EBITDA ratios of greater than 3:1 (the Senior Debt Test); (iii) a high debt to net worth ratio; and (iv) leverage permitted to exceed industry norms or historical levels.

In an effort to shed additional light on what would be considered leveraged loans subject to regulator scrutiny, the regulators issued supplemental guidance in November 2014 in the form of frequently asked questions (the "FAQ's"). The FAQ's noted that loans that are "identified as leveraged in the debt markets have all or many [such] characteristics" and that these common characteristics should only be used as a "starting point" by regulated institutions. The FAQ's also clarified that having, or failing to have, some of the characteristics would not necessarily preclude a loan from being considered to be a leveraged loan.

For example, the regulators noted that a pure use of proceeds or purpose test would be inconsistent with developing a "comprehensive risk management framework" for leveraged loans. Moreover, loans secured by tangible collateral or real estate that do not rely upon enterprise valuations for repayment would not be considered leveraged loans. This would be true even if such loans would otherwise fail to meet the Senior Debt or Total Debt criteria on the basis that the lender may have additional sources of repayment other than cash flow.

One thing that was made clear by the supplemental guidance is that the regulators will levy particular scrutiny upon leveraged loans where the Total Debt Test are in excess of 6:1. While the regulators acknowledged that this limit is not a "bright line," it was made clear in a 2015 call hosted by the regulators6 that ratios above that amount could be a "red flag." Nonetheless, many leveraged buyout transactions have historically exceeded such levels and even as late as the fall of 2014, almost 50 percent of US private equity deals had breached this threshold.7 As the demand for such loans continued, the market was slow to react to the guidance. This changed in the fall of last year when Credit Suisse received a letter from the Federal Reserve requiring it to address its underwriting and sale of leveraged loans, raising concerns that the banks' adherence to the guidance had been too lax. This highly publicized letter captured the attention of the market, and banks have been increasingly concerned about the seriousness of regulators with respect to such guidelines.

Additionally, a number of banks were summoned to an in-person meeting in New York during November 2014 where the Fed and the OCC emphasized their stance on compliance with guidelines and the ability to criticize loans on such basis. The regulators raised the possibility that they could use cease and desist orders to force discontinuation of leveraged lending activities, which captured the market's attention.8 This has naturally had a chilling effect, causing regulated lenders to become increasingly reluctant to participate in leveraged buy out and other similarly leveraged debt transactions. Moreover, there are a number of reports that banks have passed on financings for public buyouts due to the guidelines. In one highly publicized transaction, a leveraged buyout of Pet Smart it was reported that a number of well-known banks decided not to pursue the opportunity to arrange the financing of the transaction as the basis that the Total Debt Test was in excess of 6:1.9

Loan Funds and Fundraising Activity

As a result of these regulatory concerns, opportunities have opened up for unregulated institutions to act as lead arranger for highly leveraged transactions that may also lack financial covenants or otherwise receive regulator criticism. As previously noted, institutions such as Jefferies have stepped in to fill the gap and have been noted in the press as aggressively pursuing highly levered loans, thereby replacing lenders such as Credit Suisse and Bank of America for add-on or refinancings of debt previously issued by such institutions that exceed the guideline ratios.10

While investment banks that are not subject to regulation by the Fed or the OCC have increased their participation in leveraged loans, private equity funds and their investors have also been staking out their claim on desirable returns from such products. Private equity fund investors, generally comprised of pension funds, insurance companies, foundations and endowments, have become concerned about the impact of potential rate increases on their fixed income portfolios and, as a result, have sought to increase their interest in private debt just as lenders have become more cautious due to the regulatory requirements.11 In particular, these private equity fund investors are attracted to the relatively high yields ranging from 10 to 12 percent,12 and floating rates in reviewing their asset allocations, with such direct lending providing the benefit of a hedge against interest rate increases without the a diminution in investment value (as opposed to bond allocations).

Some pension funds have been so eager to enter this market that they have sought to purchase businesses that are already doing direct lending. For example, in June, it was announced that General Electric had agreed to sell its sponsor finance business as well as a $3 billion bank loan portfolio to the Canadian Pension Plan Investment Board.13 The decision was viewed as part of GE's selloff of non-core businesses. Others argue, however, that this decision reflected the exit of another regulated lender from the commercial lending business due to regulatory concerns.14

As a response to these trends and investor desire, a number of fund sponsors, including Goldman Sachs, Ares Management, Morgan Stanley and KKR, have successfully closed large direct lending funds so far in 2015. The opportunities presented from bank exits from the market have meant that current fundraising for private debt funds has been concentrated on direct lending fund strategies (39 percent), rather than more traditional special situations (11 percent) or mezzanine fund (29 percent) strategies.15 Moreover, it is expected that investor interest in private debt funds will continue, as 57 percent of investors in private debt funds intend to commit more capital to the sector in 2015 than they had in 2014.16

While private debt funds have been focused primarily on the market in North America, another trend to look out for is penetration of European and Asian markets, which seems to have increased in activity with 66 funds currently fundraising in Europe and 21 focused on Asia.17 The impact of direct lending in European markets has taken place even in the face of renewed interest by banks and a bifurcation of transactions whereby banks have taken on more "plain vanilla" transactions and direct lending funds have made inroads with borrowers attempting to execute more complicated transactions or those that require more favorable amortization terms.18 While the retrenchment of banks, due to regulatory concerns, has been a greater trend within US markets, it would not be surprising to see this bifurcation in the US market as well, as comfort with non-bank sources of leverage continues and funds remain a flexible and unregulated source of capital.


Increasing regulatory pressures on banks have created the opportunity for non-banks to stake a claim to loans that would otherwise face regulator criticism. Moreover, investor interest in chasing yield, while under the Damocles sword of interest rate hikes, has caused funds to become more interested in the market. We see this as a trend that will continue in the near future as borrowers become more comfortable with other sources of capital to suit their needs. Further, it would not be surprising to see the direct loan strategy of private funds to expand to include different types of direct loans that due to structure or complexity would require more flexibility from lenders.


1. "The Search For Yield Leads to Private Debt," Barrons April 25, 2015 and Arleen Jacobius, "Private Debt Ready for Takeoff," Pensions and Investments Apr. 20, 2015, available at http://www.pionline.com/article/20150420/PRINT/304209981/private-debt-market-ready-for-takeoff.

2. Lella Parker Deo, "LPC- Jefferies profiting from highly leveraged loans" Reuters, May 29, 2015 available at http://www.reuters.com/article/2015/05/29/jefferies-loans-idUSL5N0YK4OV20150529.

3. Prequin Special Report: Private Debt Fund Manager Outlook, August 2014 (the "Prequin Report") p. 1.

4. See Prequin Report.

5. What is generally referred to herein as "guidance" is comprised of a number of bulletins jointly issued by the OCC, the FDIC and the Fed including the following: "Leveraged Lending: Guidance on Leveraged Lending" OCC 2013-9 issued on March 22, 2013, available at http://www.occ.gov/news-issuances/bulletins/2013/bulletin-2013-9.html; OCC 2014 "Leveraged Lending: Frequently Asked Questions for implementing March 2013 Interagency Guidance on Leveraged Lending" issued November 7, 2014 OCC 2014-55, available at http://www.occ.gov/news-issuances/bulletins/2014/bulletin-2014-55.html.

6. "Regulators on Leveraged Lending: A Cheat Sheet" Wall Street Journal Online February 26, 2015. See http://blogs.wsj.com/moneybeat/2015/02/26/regulators-on-leveraged-lending-a-cheat-sheet/.

7. GillianTan and Ryan Tracy, "Credit Suisse Loans Draw Fed Scrutiny" Wall Street Journal Sept. 16, 2014, citing S&P Capital IQ LCD, available at http://www.wsj.com/articles/credit-suisse-loans-draw-fed-scrutiny-1410910272

8. Craig Torres and Nabila Ahmed, "Wall Street Banks heed Fed's Risky Loan Warnings," Bloomberg Feb. 19, 2015, available at http://www.bloomberg.com/news/articles/2015-02-19/wall-street-banks-heed-fed-s-risky-loan-warnings-credit-markets.

9. Jonathan Schwarzberg, "Thin Dealflow to Help Pet Smart's Buyout Loan," Reuters Feb. 11, 2015, available at http://www.reuters.com/article/2015/02/11/us-petsmart-dealflow-idUSKBN0LF2CE20150211.

10. Leela Parker Deo, "TRLPC: Companies Turn to Non- Banks to Increase Leverage," Reuters, Feb 20, 2015, available at http://www.reuters.com/article/2015/02/20/nonbanks-leverage-idUSL1N0VU14W20150220.

11. Jacobius.

12. Claire Ruckin, "Direct Lending Plays Bigger Role in European Loan Market," Reuters, Dec. 1, 2014, available at http://www.reuters.com/article/2014/12/01/us-direct-lending-loans-idUSKCN0JF26K20141201.

13. "GE to Sell Buyout Unit to Canada Pension Fund for $12 Billion," Ted Mann, Ben Dummett and Chelsey Dulaney June 9, 2015, available at http://www.wsj.com/articles/ge-to-sell-buyout-unit-to-canada-pension-fund-for-12-billion-1433846821.

14. Jacobius.

15. Prequin Report p, 2, Fig 2.

16. Prequin Report p. 6.

17. Prequin Report p. 4, Fig 3.

18. Ruckin.

Originally published 17 February 2016

Visit us at mayerbrown.com

Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe – Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2016. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.