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

Say on Pay in the US: The Early Evidence

Joe and I have been debating the merits of the new Swiss Say on Pay regulation.   (See Mad as Hell and I'm Not Going to Take This and Swiss Say on Pay - The Dangers. 

The US now has it's own, non-binding Say on Pay legislation, but it is a relatively new development.  A few years ago, my colleague Jay Cai and I performed the first empirical analysis of Say on Pay in the United States in the academic literature.

The starting point for our analysis was April 20, 2007, when underdog Presidential Candidate Barack Obama introduced the legislation into the Senate.  It had just passed the house on the same day.  Thinking about the impact of this legislation on shareholder wealth you can immediately envision three possible impacts.

First, it could be beneficial, prodding boards to rein in excessive pay and to be more careful in the compensation packages they offer.  In this case, the share price of firms would increase with the bill.

Second, such a law could be detrimental to shareholders.  Boards are responsible for executive compensation and can always hire additional expertise to advise them as needed.  Outside pressures from shareholders, some of whom may have narrow agendas, could produce unnecessary complications within the boardroom which could reduce shareholder wealth.

Finally, we might find that the mere introduction of the bill in the Senate (and it's passage in the house) have no impact on shareholder wealth.  After all, we are talking about the introduction of a bill, not its passage.  Moreover, even if it passed the Senate, then-President Bush said he would veto it.  Besides, it is an advisory vote - boards don't have to do anything even if a majority of shareholders disagree with the level of executive compensation.  (In this regard, I note that previous evidence on advisory votes finds them to have little impact on shareholder wealth.)  So in my mind, the probabilities were stacked towards no impact.  

What did we find?  Some interesting results.

First, we find that one size doesn't fit all with this legislation.  Our results indicate that situations where the law appears beneficial and situations where shareholder votes are likely to be seriously considered are associated with increases in shareholder wealth.  In other situations, the bill would appear to reduce shareholder wealth.  

So where was it beneficial?  In firms with high, abnormal CEO compensation, those with low pay for performance sensitivity and for those firms that had been responsive to shareholder votes in the past.  The latter result is in line with the fact that firms don't have to implement changes, even if a majority of shareholders disagree with pay packages.  

But Say on Pay could have been voluntarily implemented by boards if they deemed it beneficial.  They didn't need legislation to do this.  Moreover, shareholders themselves could have proposed Say on Pay to their boards.  In fact, this did happen.  We found numerous cases where activists (primarily unions) had sponsored Say on Pay proposals.  Unfortunately, they appeared to target the wrong firms.  The firms they targeted were large firms that, on average, appeared to have reasonable performance, governance and pay characteristics. As a result, the share price dropped for firms targeted in this way.  Our research suggests that say-on-pay creates value for companies with inefficient compensation, but can destroy value for others. 

The complete paper can be downloaded here: Shareholders’ Say on Pay: Does It Create Value? 

Increase Bank Dividends? Not So Fast

In a recent article published in the American Banker, I take a skeptical view of the practice of many banks that are currently seeking to return capital to shareholders via dividends and share repurchases.  

Although it was unthinkable a few years ago, some bankers and pundits believe banks have excess capital that should be returned to shareholders through dividends and stock repurchases. Banks have rebuilt capital positions from their depressed crisis levels largely through improved earnings from reduced credit costs. Lackluster returns on equity, limited investment opportunities and crisis-related curtailed payouts have raised the call for the return of perceived excess capital to improve ROE. ..... "   See the complete article at:  American Banker

J