Leveraged loans are a key buyout funding source. They are similar to high-yield bonds as both involve transaction-based credit to leveraged noninvestment grade obligors. LLs differ from high-yield bonds in that they are higher in capital structure, senior and secured, and usually lack call protection. Currently, LL yields, although down from the prior year, still exceed 5%, according to Standard & Poor's Capital IQ Leveraged Commentary and Data, and have attracted investor and bank attention.
Even though bank investors remain important, the LL investor market, as opposed to the origination market, has evolved into a largely nonbank institutional market.The majority of funding is provided by collateralized loan obligation funds.CLOs are structured vehicles designed to buy syndicated loans from large bank originators. Loans structured for bank-oriented investors include revolving credits and shorter duration amortizing "A" term loans. Institutional investors focus on the longer maturity "B" loans, which have minimal amortization.
CLOs, like most structured products, were dormant following the financial crisis, but returned in the second half of 2012. CLO fund-raising volume increased from $28 billion in 2011 to over $62 billion last year, according to S&P's Capital LCD. This growth is a major factor supporting the return of large buyout transactions like Dell ($24 billion) and Heinz ($28 billion). These larger deals underlie the expansion of 2013's first quarter buyout volume to $78 billion from $19 billion in the prior year same period. This represents the highest volume since the boom years of 2006 and 2007.
Regulators are concerned that LLs' high nominal yields may cause inappropriate growth in the activity by banks. This includes community banks seeking to diversify away from real estate loans. There is nothing inherently wrong with leveraged lending, provided it is done in a controlled manner. Consequently, after a prolonged comment period, regulators issued updated LL guidance last month to control the activity. This replaces the prior April 2001 guidance. The updated guidance defines leverage lending as loans to finance buyouts, acquisitions or recapitalizations resulting in leverage as a multiple of earnings before interest, taxes, depreciation and amortization of four or higher.
A key requirement in the updated guidance is the need for clear, written and measureable underwriting standards. The standards should incorporate three key risk considerations.The first is business risk or EBITDA volatility based on obligor and industry factors. A company with declining and volatile EBITDA can support less debt than the more stable one. Next, is financial risk, which is reflected in the level of debt relative to EBITDA. Current LL debt levels have increased to over five times EBITDA from around four times last year. This increase, however, appears sustainable given the current low level of interest rates and credit spreads.
Finally, there is structural risk pertaining to the priority of the creditor's claim over the debtor's assets based on seniority and security. Also, important is the control over the debtor's cash flow, leverage and assets through covenants. Thus, the guidance expresses concern over the return of boom era structures like covenant-lite and payment-in-kind securities. Covenant-lite are loans with minimal or no financial maintenance requirements such as maximum debt or minimum interest coverage ratios features. PIK securities are negative amortization instruments in which interest is "paid" by issuing new securities, which are added to the principal balance. These structures are usually employed to expand debt capacity and reflect an increase in market risk appetite.
The buyout market, like all transaction driven markets, is cyclical.It experienced substantial issues during the financial crisis from which it took years to recover. Currently, investors, including banks, searching for yield are supporting a return to more aggressive, higher-risk transactions. Consequently, banks need the discipline of fixed underwriting standards to prevent mindless herding. This is difficult as it means being out of the market at times.
The likely consequence of the guidance, along with higher capital charges for loans in general, is to slow bank LL investor activity relative to CLOs. Transaction originators will likely respond by increasing nonbank-oriented B term loans at the expense of bank investor focused revolving credits and "A" term loans. Nonetheless, adhering to a sound underwriting policy can protect banks from losing their way in volatile LL market, while benefiting from its growth.
J.V.Rizzi is a banking industry consultant and investor. He is also an instructor at Loyola University Chicago.