The Chairman's View: The ECB Guidance on Leveraged Transactions
The European Central Bank (the “ECB”) has released its final Guidance on Leveraged Transactions (the “Guidance”) which will take effect from 16 November 2017. The introductory remarks in the Guidance state the ECB’s primary aim is monitoring “credit quality and exposure to leveraged transactions”.
In essence the ECB Guidance requires significant credit institutions that it regulates and which underwrite or syndicate Leveraged Transactions, where leverage is greater than 6.0x at inception, to do so only in exceptional and justifiable circumstances and to ensure that borrowers are able to fully amortise senior secured debt or repay at least 50% of the Total Debt over five to seven years (when did I last see amortization on this scale in a loan agreement- I was a lot younger!). I have italicized certain terms/definitions which I shall discuss later- and thoughts in this blog (perhaps obviously!) only apply to relevant regulated credit institutions.
Intentionally or otherwise the Guidance hits not only leveraged deals generally but also any PE “Sponsored” transaction irrespective of the actual leverage. Since this latter “PE” test lacks any quantitative aspect it is difficult to reconcile its inclusion with the ECB’s stated aim to monitor credit quality and exposure. Moreover this latter test is out of kilter with the US Leveraged Guidance (the “US Guidance”) which does not specifically include sponsored deals but adopts a more wide-ranging qualitative approach referring to “proceeds used for buyouts, acquisitions or capital distributions”.
The Guidance applies to “all types of loan or credit exposure where post-financing leverage exceeds 4.0 times Total Debt to EBITDA.” Exposure refers to all gross direct commitments to a leveraged borrower, including drawn and undrawn facilities, term loans, bridge loans or revolving credit facilities, committed exposures not yet syndicated or distributed, and exposures being warehoused for a later sale.
In the original draft guidance the definition of “EBITDA” was extremely restrictive referring to “unadjusted EBITDA, i.e. realized EBITDA over the previous 12 months with no adjustments made for non-recurring expenses, exceptional items and other one-offs.” This would have had a major (negative?) impact on a market which (for better or worse - another topic!) operates on “adjusted” EBITDA. This narrow approach was an attempt to address (justifiable?) concerns over the increasing add-backs to EBITDA adopted by the market in recent years (many imported from high yield bonds) which arguably go well beyond deriving a realistic underlying run-rate EBITDA for the borrower. Fortunately the final Guidance rowed back from this approach and now EBITDA is more in line with U.S Guidance although it does require any enhancements to EBITDA to be justified and reviewed by a function independent of the front office function. No doubt the identification and operation of this function will be a headline matter for regulated market players in coming months.
The “Total Debt” element of the Leverage Test potentially poses much greater problems since it captures various forms of debt which would perhaps surprise seasoned market practitioners (they surprised me!). The Feedback Statement (which accompanied the Guidance), clarifies that Total Debt includes PIK instruments, Shareholder loans and Vendor loans whilst cash balances are not to be netted off. Whilst the treatment of cash balances is less controversial, and is in line with U.S. Guidance, it should be borne in mind that cash available to service debt is netted off in the Leverage covenant in the LMA Leveraged loan precedent.
I find the general inclusion of PIK, shareholder loans and vendor loans (all generally non cash pay debt other than in specific pre agreed tested circumstances) far less justifiable given the ECB’s aims. Why include in Total Debt indebtedness which has no recourse to the “Restricted Group” (for these purposes the operating business which provides the credit support for the loans). A great deal of work has gone into creating deal structures which in effect remove non cash pay instruments from having any practical effect on debt to the Restricted Group. The ECB seems to ignore this.
PIK facilities (which may be loans or bonds) tend to come with (if any) two possible payment varieties; Toggles, which allow the borrower to elect whether or not to pay the coupon, or Pay-if-you-Can (“PIYC”) where, in simple terms, the coupon payment becomes payable only if the borrower has generated sufficient profits to pay the coupon (although whether it has sufficient cash is another issue). PIK is generally deeply subordinated being outside the Restricted Group and subject to onerous payment (and enforcement) standstills even if the coupon remains unpaid when due (e.g. if a PIYC). The commercial position is that so far as the Restricted Group is concerned it is “equity”- which makes bringing it in consideration when considering (senior) credit exposure strange.
Much of the “equity” element of most leveraged transactions from the PE sponsor funds is usually injected by way of shareholder loans (SHL) for a variety of purposes. These SHL (which are expressly structured to have little/none of the rights generally associated with debt other than the right to be repaid, generally after all other debt) often comprise a very high proportion of the “equity” (in many cases over 90%) which means that all but the smallest leveraged transactions would be caught by the Guidance as well as any sponsored transaction. In simple terms - a transaction with EBITDA of 10m and an enterprise value 80m (8.0 times EV) with 4 times first and second lien debt (i.e. 40m) and 30m shareholder loans (75% of the 40m equity) would carry opening leverage of 7.0 times. The Guidance states that transaction exceeding 6.0 times leverage “should remain exceptional … and a potential exception should be duly be justified”. I would guess including SHL will result in almost all sponsored deals being “exceptional”- perhaps credit institutions will have standard pro forma justification!! Was this the intention?
A better approach might have been to use a test of the ability (or not) for PIK/SHL/vendor notes to be cash pay and if so upon what conditions (such as low leverage!). Some credit institutions in the U.S. have adopted a policy of including shareholder loans as leverage only if they carry a running yield non-payment of which is an event of default. In my view the inclusion of shareholder loans in Total Debt seems totally at variance with the ECB’s aim to monitor credit quality – after all generally the view is the more the equity the better for the lenders!.
A further area of future confusion relates to incremental and other debt baskets. The Guidance specifically states (in a footnote) that “Total Debt” refers to total committed debt (including drawn and undrawn debt) and any additional debt that loan agreements may permit. At first blush this suggests that incremental debt, accordion facilities and the wide range of general, freebie and side-car debt baskets should all be included in Total Debt. Many of these baskets are currently structured on a “grower” basis being the greater of a fixed amount or a percentage or multiple of a variable, increasingly EBITDA (or Total Assets). In this context should the value of the baskets at inception be based on the fixed amount or the variable amount or the greater of the two (as at the relevant time)? The point is not clear and is remains open for discussion.
Turning to some final points of difficulty. The Guidance does not apply to all lenders but only to significant credit institutions (supervised by the ECB); this excludes credit institutions in the UK or those which are in the EU which are not significant as well as direct or alternative lenders. The emphasis on ‘significant’ (as well as the uncertainty as to how this will be measured) together with the exclusion of alternative lenders, who already play an important role in the leveraged market, may lead to a further bifurcated market- but this can hardly be laid at the door of the ECB.
Finally, the Feedback Statement clarifies that whilst leveraged transactions cover the entire debt structure this does not include “bonds and non-investment grade bonds (“high-yield bonds”) held by bank and non-bank investors.” To call this odd would be complimentary (I can think of stronger adjectives). Regulate the loans but not the bonds? As a “significant credit institution” am I more at risk if I hold (on identical terms) a leverage loan rather than a high yield bond which is credit supported by the same Restricted Group. I think not.
Further this is anomalous as many larger deals (which tend to be more highly leveraged and thus the primary target of the Guidance), include both loans and bonds in their capital structure (and very complex documentary terms are written expressly to allow companies to move between both loan and bond markets at will). Could this exemption represent a further safe-harbour by allowing regulated credit institutions to evade the Guidance by structuring a significant portion of the debt in the form of bonds? [Incidentally, the market explored structuring loans as bonds (capital market instruments] in 2003, following the introduction of the Enterprise Act as bonds continued to allow the appointment creditors to appoint a Receiver]
For Debt Explained which holds in its databases (bond and leverage loans) detailed information on all the elements which the ECB is covering (amount and nature of various debt in the structure, amounts and terms plus calculation of EBITDA etc) the Guidance feels to me like Christmas. Go ECB!
But as a practical matter the Guidance appears to have fallen between three stools. It has failed to hit its primary target (whilst creating a level of confusion) and, at the same time, has adopted an approach out of sync with the US Guidance. I can’t believe the points above- and others- were not raised prior to issuance of the Guidence. Were people listening or did they not want to hear?
-- Stephen Mostyn-Williams, Chairman of Debt Explained
Stephen founded Debt Explained in 2007, following a 25 year career in leveraged finance. He has held senior positions at Cadwalader, Wickersham & Taft LLP; Shearman & Sterling LLP and Ashurst. Stephen co-founded the European High Yield Association and served as its chair for the first three years of its existence.
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