You may just have noticed that the global debt crisis has not abated since the global financial crisis. In fact, we are still knee deep in unprecedented levels of debt. You may also have heard that the covenants surrounding many corporate loans and bonds are being eased. Which is usually a great signal of lax lending standards. But surely those engaged at the coal face of lending – leveraged lenders – have learnt their mistakes from 10 years ago?
On current evidence, possibly not.
Done properly, specialist leveraged lending shops – CLO firms for instance – can crank out great returns for investors. But I’ve been spooked about talk of increasing loan multiples and consequent lax credit policies. Now we have some more granular analysis courtesy of Matt Hose, the listed funds’ analyst at Jefferies. He’s drawing attention to the relaxing of U.S. regulators’ guidance on leveraged lending (the 6x cap). As a fund’s analyst, Hose is mostly focused on the impact on funds of course – and also listed private equity firms.
But I’d suggest this analysis has much wider implications and should act as yet another warning sign of trouble to come. Hose draws particular attention to a joint statement made in mid-September by U.S. federal agencies including the Federal Reserve and the Office of the Comptroller of the Currency (OCC).
“ The statement confirmed that prior regulatory guidance was no longer legally binding and agencies will not take enforcement action based on it. The most obvious application is the leveraged lending guidance for regulated banks, established in 2013. As a reminder, the guidance capped pro-forma leverage for leveraged financings (i.e. private equity deals) at 6x total debt/EBITDA and required a company be able to amortise at least 50% of its debt within 5-7 years of the deal closing. This echoes comments made by Joseph Otting, the head of the OCC, at a conference in February (as reported by Debtwire), stating ‘institutions should have the right to do the leveraged lending they want, as long as they have the capital and personnel to manage that and it doesn’t impact their safety and soundness’. Later concluding ‘I do think you will see leverage ratios float up over the next 12-18 months’……
“ Our interest is piqued given that we have already seen continued evidence of rising debt multiples within the portfolios of listed private equity funds…while there are examples of deals with high leverage already held within the portfolios, if numerous U.S. deals with 6x or 7x leverage start to be acquired, average debt multiples could increase further. Each transaction understandably has to be assessed on its own merits, but this may still add to wider concerns over the various funds’ exposure to an arguably overheated private equity market, with too much money chasing too few deals….
“ In September, S&P warned of private equity’s aggressive use of EBITDA add-backs when seeking debt financing for deals. The S&P study of a sample of fifty 2015 vintage M&A and LBO transactions found an average of 45% of EBITDA was the result of add-backs from management, with a trend of greater use of add-backs for the lower (i.e. single B) rated deals. Furthermore, when tracking EBITDA projections at deal inception against the subsequent performance of the companies over the following two years, S&P found both actual EBITDA growth and deleveraging efforts fell materially short of expectations. The result is leverage levels could potentially be understated, while the ability to repay debt could be overstated”
Anyone reading results from the listed private equity industry will know that some of the more experienced PE players such as Hg Capital have been growing wary about high multiples quoted on M&A activity.
It’s hard not to agree with this caution but most investors might just shrug off these concerns as PE specific. My concern, by contrast, is of wider systemic impacts. What happens if a huge series of loan books within the PE sector starts to turn toxic? The big banks will be forced to take big losses and possibly restrict credit to new borrowers. More pertinently many pension funds have, in my view at least, overcommitted to the private equity space and thus may be forced to take heavy losses to pensioner payouts.
In sum, might lax leverage lending (LLL) prove to be the canary in the coal mine, warning us all of the next downturn?
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