PE houses in Europe have benefitted in recent years from the availability of “Yankee” financings — access to the US leveraged loan markets to support buyout and refinancing activity in Europe, at low interest rates, with significant operational flexibility and often on a “covenant lite” basis. The availability of these “Yankee” financings has also provided PE houses with negotiating power to obtain better pricing and more flexible terms from local lenders. Enhanced regulation of leveraged loans in the US, however, is altering this environment.
Last year the US Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation — the three institutions charged with regulation of most banks doing business in the US — began heightening their scrutiny of the leveraged loan market, taking a much closer look at individual deals which arrangers were offering in excess of six times a company’s EBITDA, a long established but often ignored guideline. Regulated banks have been required to develop or refine their own internal standards on how to assess and whether to underwrite these higher leveraged loans. This increased scrutiny has led to a good deal of uncertainty in the US leveraged loan market and we expect this to filter into Europe, partly because of the growing interconnectedness of European and US debt financing.
PE houses in Europe may find that their financing options are narrowed by the increasingly restrictive US regulatory landscape. Not only may “Yankee” financings be less available to support European PE activity, European regulators are showing signs of taking notice of the Fed’s apprehensions. At the end of 2014, The Sunday Times reported that the Bank of England was to conduct "spot checks" on UK-based lending to PE houses, as the bank reportedly became increasingly concerned about deals backed by growing levels of debt. As a result, PE houses may have to face up to tighter leverage, higher pricing terms and less operational flexibility in their loan documentation.
Setting aside new issuances supporting new investment activity, if regulators’ concerns signal a change in the lending landscape then these concerns could have real implications for the refinancing of existing deals. For example, if an investment has not worked out as expected and if EBITDA has decreased, leveraged lending limitations could significantly complicate a refinancing. At the extreme end of the spectrum, increased regulation could push the portfolio company into a workout or insolvency situation when — absent the tightened leverage restrictions — debt maturities otherwise could be extended (albeit with higher pricing and tighter operational controls and monitoring, as would be expected in most workout scenarios). Similarly, for PE sponsors that execute buy-and-build strategies, they could struggle to finance these additional acquisitions as leverage guidelines could decrease the availability of committed financing many PE houses use to execute such growth strategies. Leverage restraints could also increase the difficulty of extending revolving credit facilities for high leverage portfolio companies, hampering working capital requirements.
We expect that PE houses in Europe will need to adjust to life under this new regulatory landscape, and we expect that UK and European regulators are likely to follow suit. Still, PE houses may be able to navigate this environment successfully by increasing the number of banks approached to arrange financings, as internal compliance mechanisms vary from one to another. A number of lending institutions that fall outside the scope of the US leveraged lending guidelines can also play a role. We have seen a noticeable uptick in activity by this type of institution, both in arranging original issuances but also in providing committed financing for tack-on acquisitions. We expect more and more lending activity going through these institutions, particularly while regulatory uncertainty lasts, both in the US and in Europe. Leverage guidelines are not a hard-and-fast rule either, financial institutions take into account other factors, such as the portfolio company’s projected cash flow to service debt. Leveraged lending will of course continue to remain an important part of PE investment activity, it is just significantly more complicated to determine how.