The Regulatory Shot across the Bow

Leveraged loans (LL) are a key funding source for buyouts. They are similar to high yield bonds. They both involve credit to highly leveraged non investment obligors. LL differ from high yield bonds as they are higher up in the capital structure, senior and secured, and usually lack call protection. Currently, LL yields, although down from the prior year, still exceed 5%, which has attracted investor and bank attention.

Even though banks remain important, the LL investor market has evolved into a largely non bank institutional market. The majority of funding is provided by collateralized loan obligation funds (CLOs). CLOs are structured vehicles designed to buy loans. Loans are structured for bank orientated investors include revolvers and shorter term amortizing term loan As. Institutional investors focus on the longer term loan Bs which have minimal amortization.

CLOs went dormant following the financial crisis, but have returned in the second half of 2012. CLO fund raising volume increased from $ 28B in 2011 to over $ 62B last year. This growth is a major factor supporting the return of large buyout transactions like Dell ($24B) and Heinz ($28B) in the first quarter of 2013.These larger deals underlie the expansion of  1Q13 buyout volume to $78B from $19B in the prior year same period. This represents the highest volume since the boom years of 2006 and 2007.

Regulators are rightly concerned that LL’s high nominal yields may cause an inappropriate growth in bank loans in this area. This is especially true for yield hungry community banks. They are increasing their LL exposure through organizations such as BancAlliance, which now counts more than 100 community bank participants. Consequently, they issued revised regulations last month to control the activity LL GuidanceMarch,2013 .

 Current LL debt levels, as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA), have increased to over 5 times from around 4 times last year. This increase, while aggressive, appears sustainable given the current low level of interest rates and credit spreads. These developments have reduced yields from 7% to 5% in the past year.

Equally concerning to the regulators is the return of boom era structures like covenant lite and payment in kind (PIK) securities. Covenant lite as its name suggests are loans with minimal or no covenant features. PIK securities are negative amortization instruments in which interest is “paid” by issuing new securities, which is added to the principal balance. Structures like these are usually employed to expand debt capacity reflecting weakening underwriting standards.

The likely consequence of this regulatory shot across the bow, along with possible higher capital charges for LL, is to slow bank LL activity relative to CLOs. Transaction originators will likely respond by increasing non bank orientated term loan Bs at the expense of bank focused revolvers and term loan As. Something to keep an eye on as this is implemented.

J