Monday, February 10, 2014

Financing Structure and Banking Regulations

Financial structuring involves two levels of analysis (see the slide below which is part of our Amsterdam Institute of Finance course). 

The first level is the deal environment, which includes:
  • Business Considerations - the corporate strategy and plans
  • Financial preferences - dilution, control and flexibility (covenants)
  • Transaction Characteristics - size, debt rating
  • Market Conditions - availability, depth, and pricing

The second level is the institutional level which depends on the domicile of the deal. Factors are as follows:
  •               Legal
  •               Tax
  •               Accounting
  •               Regulatory

Acquisition finance, especially leveraged lending to non investment grade obligors has incurred significant domestic banking regulatory changes since the 2008 financial crisis. Regulators are concerned that banks will be attracted to risky deals, buyouts and real estate, given their higher nominal spreads.
Their concerns are not without merit. Leveraged loan activity reached record levels in 2013. Also, leverage levels approached pre crisis levels of 6X EBITDA. Pricing has declined while structures have weakened with the return of Cov-lite and PIK Toggle instruments to further expand debt capacity. Amortization has fallen with only minimal principal reduction during the first 5-7 years. Finally, the percentage of leveraged loans for higher risk recaps in which sponsors pay themselves a debt financed dividend have risen.
Consequently, regulators passed Updated Regulations on bank related leveraged lending in 1Q13 .The regulation highlighted areas of increased concern during subsequent loan reviews in the following areas:
  •                Leverage over 6X total or 4X senior
  •                Amortization less than 50% over 5-7 years
  •                Use of Cov-lite and PIK toggle
  •                Recap transactions

A  Shared National Credit Review later that year was especially hard on leveraged loans. Almost 75% of SNC criticized or special mention loans were leveraged loans.  This highlights that the regulators are serious about enforcing the revised regulations. Banks, despite revenue needs, are likely to reduce leveraged loans that are inconsistent with the guidelines to avoid regulatory issues. This means more conservative structures just when buyout prices are reaching high levels due to the 30%+ increases in the stock market in 2013.
The likely market responses include:

1)     Banks continue to lend and incur regulatory issues
2)     Leverage levels decrease putting pressure on private equity buyer returns
3)     Non bank loan investors like CLOs assume a larger buyout financing role. Regulators are likely to be concerned with such a development. It involves the same level of systematic risk, but moves it into shadow banking system. Additionally, other regulations have made it more difficult for banks to invest in the senior tranches of CLOs. This could curtail CLO growth.
4)     Investment grade strategic buyers assume a larger role relative to private equity
5)     Bank leveraged lending by larger arranging banks stalls. Regulators will pay increased attention to the arranger bank underwriting and syndication risks.
6)     Some new structuring instruments are developed to bridge the regulatory gap
7)     Syndication activity involving smaller bank investors may be negatively impacted

The impact on buyouts and leveraged loans of these regulatory developments remains a work in process, which we will be following throughout the year. Financial structuring is a dynamic multi level task, which has become more complicated by these regulatory changes. They affect all members of the buyout eco system-borrowers, lenders, private equity, and private equity targets.


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