Heightened U.S. regulatory scrutiny of leveraged lending is leading the biggest banks to back away from funding some takeovers financed by debt, creating an opportunity for smaller competitors to step in.
JPMorgan Chase & Co., Bank of America Corp., Credit Suisse Group AG, Deutsche Bank AG, Barclays Plc and Morgan Stanley are among banks that have passed on the opportunity to fund deals the past few months, according to people with knowledge of the matter who asked not to be identified because they weren't authorized to speak publicly.
The trend has accelerated as the Federal Reserve and Office of the Comptroller of the Currency step up their oversight of financial firms that haven't abided by previous industrywide guidelines issued last year. The crackdown is hurting banks' leveraged-lending fees, contributing to a 16 percent decline during the first nine months of the year, according to Brian Kleinhanzl, an analyst at Keefe, Bruyette & Woods Inc.
"If the regulators are looking at every deal, there are going to be deals that banks can't do," said Kleinhanzl, who is based in New York. "We expect pressure on the underwriting fee revenues as banks pull back."
Increased Scrutiny
Bank revenues from U.S. leveraged loans dropped to about $6.1 billion in the first nine months of this year, from $7.3 billion in the same period last year, according to Dealogic.
Regulators shifted to a deal-by-deal review of the debt in the past couple of months, showing new urgency in avoiding the kind of risky lending that was blamed for igniting the financial crisis, people with knowledge of the matter said last month. They previously collected loan data in an annual survey, telling banks last year they needed better adherence to underwriting standards published in March 2013.
Regulators are concerned that there are signs of a bubble in the $800 billion leveraged-loan market that's swelled about 34 percent since 2008, according to Standard & Poor's Capital IQ Leveraged Commentary & Data.
Demand for the relatively high yielding debt, which banks sell to investors such as mutual funds and collateralized loan obligations, has surged while the Fed has kept its benchmark interest rate near zero since December 2008.
Rising Leverage
Borrowers have taken advantage of the demand by issuing loans that lack certain protections for lenders such as limits on debt levels relative to earnings. These loans, known as covenant light, are on track to exceed 70 percent of issuance this year, according to a Sept. 5 Barclays report. That would be a record.
Leverage has also gone up, even though underwriting guidelines issued by the Fed, OCC and Federal Deposit Insurance Corp. last year said a debt level of more than six times a measure of earnings "raises concerns."
Total debt for large leveraged buyouts rose to 6.26 times earnings before interest, taxes, depreciation and amortization during the third quarter from 5.89 times in the first half of the year, according to S&P's Capital IQ LCD. That compares with an average of 6.23 times in 2007, the year the credit crisis began.
"We think the market is a bit frothy," Federal Reserve Bank of New York President William Dudley said Oct. 7 in Troy, New York. "We are following up with those banks to see how closely they are following the guidance."
Tibco Deal
While identifying leveraged loans as a potential area of froth, supervisors are focusing on underwriting rather than trading, which is still conducted in telephone calls, faxes and e-mails. Loans aren't regulated as securities and take weeks to change hands, increasing the risk of a market seizure in the case of accelerated withdrawals from funds that buy the debt.
As regulatory pressure on underwriting standards has increased, banks have turned down more deals. Barclays decided not to fund a private-equity buyout of Redwood City, California- based photo-sharing site Shutterfly Inc., which has been shopping itself to funds since July, according to people with knowledge of the deal.
Gretchen Sloan, a spokeswoman for Shutterfly, declined to comment.
Bank of America, Deutsche Bank and Credit Suisse backed away from financing Vista Equity Partners' more than $4 billion deal to buy Palo Alto, California-based Tibco Software Inc., which JPMorgan and Jefferies LLC are underwriting, according to two people with knowledge of the buyout announced last month.
Christina Lema, general counsel for Vista Equity Partners, didn't return telephone calls seeking comment.
Regulatory Pressure
"You'll see more of that if banks are really pressured by regulators," said Beth MacLean, a money manager at Pacific Investment Management Co. The Newport Beach, California-based firm oversees about $1.9 trillion, including the world's largest bond fund, the Total Return Fund.
Spokesmen for New York-based JPMorgan; Charlotte, North Carolina-based Bank of America; Zurich-based Credit Suisse; London-based Barclay; Frankfurt-based Deutsche Bank and New York-based Morgan Stanley declined to comment.
Jefferies, the 12th-largest underwriter of U.S. leveraged loans sold to investors, is also arranging $1 billion of loans for Vista Equity Partners' takeover of TransFirst Inc., according to a person with knowledge of the financing. Some larger competitors passed on the deal because it would leave the Hauppauge, New York-based payments processor with leverage exceeding regulators' guidelines, according to another person with knowledge of the buyout.
Underwriter Rankings
Nomura Holdings Inc., which ranks as the 22nd-biggest underwriter of U.S. leveraged loans sold to institutional investors, and Guggenheim Partners LLC, which is the 37th largest, may help arrange the financing, according to people with knowledge of the deal. Spokesmen for Guggenheim and Nomura declined to comment.
"We have not seen a material change in the mix of our leveraged lending business this year and our underwriting standards are consistent with how we have operated over the past ten years and through business cycles," Richard B. Handler, chief executive officer of New York-based Jefferies, wrote in an e-mailed statement. "It is business as usual as two thirds of our deals are for repeat clients who we value greatly."
Jefferies, which is overseen by the U.S. Securities and Exchange Commission and is outside the purview of banking regulators, has increased its market share to 3.3 percent this year from 2.6 percent in 2013, according to data compiled by Bloomberg.
Surgery Partners
In July, Jefferies helped arrange $1.36 billion of term loans backing H.I.G. Capital LLC's Surgery Partners' purchase of health care facilities operator Symbion Holdings Corp. from Crestview Partners, Bloomberg data show.
JPMorgan and Morgan Stanley both steered away from the funding the deal, according to a person with knowledge of the matter. The acquisition was expected to increase the debt of the Chicago-based operator of ambulatory surgery centers to about 8.4 times a measure of earnings, Moody's Investors Service said in a July 18 report.
Regulated banks are still doing some deals outside the guidelines, making exceptions for some riskier financings. JPMorgan opted to use one of its exceptions to finance Vista's takeover of Tibco, according to a person with knowledge of the matter who said the bank expects to take a couple exceptions each year.
The pattern hasn't slowed takeovers. There were 741 private-equity acquisitions in the third quarter, the most since the second quarter of 2011, Bloomberg data show. The total volume of the deals is $181 billion, the largest quarterly sum since the second quarter of 2007.
While investors appreciate regulators' concerns, ultimately they will decide whether loans are too risky or not to buy, said Jonathan Insull, a New York-based money manager at Crescent Capital Group LP, which oversees about $15 billion of speculative-grade debt. "It's up to individual investors to analyze and determine what's appropriate."
