June 5, 2017
The European Central Bank (the "ECB") published its final Guidance on Leveraged Lending Transactions (the "ECB Leveraged Lending Guidance") on May 16, 2017. The ECB first published draft guidelines in November 2016, and the publication of the final ECB Leveraged Lending Guidance followed a period of public consultation, including input from key industry players including credit institutions and market associations. There is a six-month implementation window before the ECB Leveraged Lending Guidance comes into force and will apply in practice.
Both the ECB Leveraged Lending Guidance, and the similar guidance that was issued by the US federal bank regulatory agencies in March 2013 (the "US Leveraged Lending Guidance"), have the backdrop of the financial crisis, and the surprisingly strong recovery of both the European and US leveraged finance markets since that time, at their core. The US Leveraged Lending Guidance applies to federally regulated financial institutions in the US only. As competition between credit institutions for leveraged lending business has increased, and more borrower-friendly lending conditions have emerged in Europe – often coming from directly across the pond e.g. the introduction of "covenant-lite" loans – the ECB has been keen to mitigate risk and curtail the exposure of credit institutions within the European leveraged lending market.
The ECB Leveraged Lending Guidance has emerged against this backdrop, and outlines the criteria by which the ECB expects banks to assess the credit quality of their so-called "leveraged" transactions, and to monitor any underling risks to their balance sheet. These principles are very similar to those established by the US Leveraged Lending Guidance. In short, the ECB specifies that the underwriting of transactions with a leverage, or Total Debt to EBITDA, ratio (see below) of more than 6.00 times should only be undertaken in exceptional and justifiable circumstances, and that credit institutions should ensure leveraged borrowers have the capacity to fully amortize their debt, or repay at least 50% of the total amount, over a period of five to seven years. Commentary suggests that the ECB expects the ECB Leveraged Lending Guidance to be implemented consistently with the size and risk profile of institutions’ leveraged transactions relative to their assets, earnings and capital.
The ECB Leveraged Lending Guidance applies to all "significant" credit institutions supervised by the ECB, each of which is expected to adopt the ECB Leveraged Lending Guidance as an integral part of its internal policies. Whether an institution is "significant" is determined by reference to a number of criteria, but particular attention will be paid to its size, importance to the economy of the European Union or any European Member State, and also the extent of its cross-border activities. This emphasis on "significant" does mean that a disconnect could develop between large-volume arrangers and smaller banks. In addition, the ECB Leveraged Lending Guidance does not apply to non-bank institutions, e.g. direct lenders, and therefore a further divergence between these two sets of institutions is inevitable.
To be treated as "leveraged", a transaction must meet at least one of the following tests: (i) where the borrower’s post-debt incurrence leverage exceeds a Total Debt to EBITDA ratio of 4.0 times; or (ii) where the loan or other credit exposure, regardless of the actual "leverage" of the transaction, is advanced to a borrower which is owned or controlled by one or more financial sponsors. Whilst the leverage test aligns closely to the US Leveraged Lending Guidance, the so-called "sponsor test" is not only not quantitative but also inconsistent with the approach taken in the US where an equivalent test does not apply. The two tests above apply strictly to all leveraged transactions — including best efforts deals, club deals, and bilateral lending – although credit institutions are encouraged to apply the ECB Leveraged Lending Guidance to all (i.e. including non-leveraged) transactions.
For the purposes of satisfying the leveraged test above, the calculations of Total Debt and EBITDA are key. By way of example, Total Debt applies to total committed debt (both drawn and undrawn), and also any "additional" debt that the underlying loan documentation permits, whether or not such additional debt is ever tapped. This latter point is particularly relevant given the flexibility included within recent leveraged loan documentation to incur additional debt, whether by way of incremental or "accordion" debt, or "side-car" facilities. Ambiguity remains as to whether the ECB Leveraged Lending Guidance applies also to permitted debt baskets. In relation to EBITDA, following the consultation process on the draft ECB Leveraged Lending Guidance (referred to above), certain pro forma adjustments and add-backs to EBTIDA are now permitted to be made. However, such adjustments must be duly justified and reviewed by an independent function within the credit institution – whilst the principle of the adjustments is in line with the US Leveraged Lending Guidance, the independent review is an additional criteria unique to Europe. The ECB has reserved the right to re-assess its position on EBITDA adjustments if it feels that there is a consistent over-zealous application of pro forma "future synergies" or "future earnings", which goes against the mitigation of risk that the ECB Leveraged Lending Guidance is designed to achieve.
The ECB Leveraged Lending Guidance does not apply to credit institutions that do not participate in the Single Supervisory Mechanism Regulation (i.e. the United Kingdom and Switzerland), and there are also a number of exempted transactions. Thus, for example, loans to investment grade borrowers, and project finance, real estate and asset and commodities financing are classified as "specialized lending" and remain outside the scope of the ECB Leveraged Lending Guidance. In addition, the ECB Leveraged Lending Guidance is not legally binding, although the ECB have confirmed that compliance will be enforced through the ongoing supervision of credit institutions. It is difficult to see how a relevant credit institution can avoid incorporating the various parameters into its internal policies, and we expect that most institutions will follow the ECB Leveraged Lending Guidance as a matter of good practice. We will have to wait to see whether or not the Bank of England – possibly post-BREXIT – will follow in the ECB’s footsteps and formalize any UK-specific guidance.
In practice, deal statistics in the US show that the leverage constraints following on from the implementation of the US Leveraged Lending Guidance have led to sponsors increasing the size of their equity contributions in leveraged buyouts, although there has been little "improvement" in lending terms (i.e. terms are no more "bank friendly"). In the last couple of weeks since the ECB Leveraged Lending Guidance was published, there has been chatter within the European sponsor community that arrangers now only have a few months to squeeze through highly leveraged deals. Whilst deals of around 6.00 times leverage may still be possible, arrangers have been warned that these instances should remain exceptional, and that any potential exception should be duly justified. It will also be interesting to monitor how the flexibility around a borrower’s ability to incur additional debt is curtailed (or not, as the case may be). In any event, it is inevitable that the second half of 2017 will see leverage multiples again become an increasing focus within the European leveraged finance markets, and it is likely that there will be a fall in the number of buyouts where highly leveraged financing packages are offered – at least from the outset. We may also see an increase in asset-backed and commodities financings, as these financings are likely to be able to offer the same documentation flexibilities as more traditional leverage lending, but will be exempt from any constraints on leverage.
Of course, as we note above, the ECB Leveraged Lending Guidance only applies to a portion of institutions active in the European leveraged finance markets, whether by size or geography, and only to bank lenders (rather than non-bank or so-called "direct" lenders). This means there will still not be a level playing field across the market. In addition, the guidance impacts only those deals with "high" leverage – which, whilst headline-hitting for the European leveraged finance press, in reality relates only to a limited percentage of deals by volume. The irony is that now the European market has finally caught up with the US by implementing such ECB Leveraged Lending Guidance, the markets may be about to fall out of regulatory sync again: as part of the review of financial regulation by President Trump, the US Leveraged Lending Guidance could be cast aside…
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