Mid-Market Trends - Leveraged Lending and the Current Regulatory Environment

by Pepper Hamilton LLP

This article was published in the September 2015 issue of Middle Market Growth, a publication of the Association of Corporate Growth. It is reprinted here with permission.

Financial institutions, institutional investors and liquidity providers to the leveraged loan markets are finding themselves increasingly subject to new regulation in the United States and abroad. Both global and U.S. regulators have focused in recent years on the lending and lending-related activities of these organizations, and the "cost of regulatory capital" for those who originate and distribute leveraged loans is higher than ever. In fact, GE Capital's recent plan to shed its designation as a "systemically important financial institution" demonstrates the real effects of this increase in regulation. Of particular direct and significant impact are:

  • The risk retention rules, due to take effect in December 2016, pursuant to which managers of collateralized loan obligations would need to retain "skin in the game"; and
  • The Interagency Guidance on Leveraged Lending ("the Guidance"). Issued under the joint sponsorship of the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System, the Guidance intends to set guidelines for credit and underwriting policies for its regulated entities. The Guidance has several pieces that impact deal execution, including (1) a statement that a leverage level after planned asset sales in excess of six times total debt/EBITDA raises concerns for most industries and (2) an increased focus on a borrower's capacity to repay and ability to de-lever to a sustainable level over a reasonable period.

If the parties involved in a leveraged financing wanted to minimize regulatory oversight, they generally have either avoided traditional bank products by focusing on the high-yield and private-placement markets or have focused on nonregulated entities as the providers of debt capital. In the large-cap syndicated debt markets, this has translated to more transactions being arranged by nonbank entities, where lenders are high-yield debt or loan accounts subject to regular redemption by their holders. This could potentially create a liquidity crisis as the short-term liabilities seem mismatched to the long-dated loan assets. However, in the current environment (this article was written before the planned Greek referendum of July 5, 2015), where the money supply is abundant, borrowers and issuers now enjoy more favorable terms, such as covenant-lite, "builder and grower baskets," incremental facilities, equity cures and, more generally, a convergence of deal terms between the leveraged loan and high-yield debt markets.

Because of increased regulation, in the midmarket debt space there has been a proliferation of alternative capital sources, such as hedge funds, mezzanine funds, business development corporations, small business investment companies and other direct lending outfits—known as the "shadow banking" industry. These capital sources are essentially buy-to-hold investors. In the absence of ample liquidity in the middle market, they are more focused on credit quality and underwriting standards while also offering products that are more customized to fit the needs of borrowers or issuers. Midmarket loans originated by these capital sources tend to have comprehensive mandatory prepayment provisions, robust affirmative and negative covenants and, most often, at least one or two financial maintenance covenants. It appears then that the private marketplace has been able to impose some credit discipline, as the Guidance aims to do. The leveraged lending space will continue to evolve with regulatory and other pressures to efficiently match supply and demand for debt capital.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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