No buyout financing, yet Leveraged Transaction?

Executive summary

Since the financial crisis of 2008, the ECB has been tightening its regulation on lending activities of European banks. A well-known example in this context is the implementation of Basel IV from 1 January 2023, which will limit the results of internal risk models. However, a more recent development has more impact on corporate lending than Basel IV. One of the lending markets that is currently under scrutiny of the ECB is the so-called “leveraged finance” market. Traditionally the area of shrewd private equity investors, where accompanying banks can earn a lot of money, but where large risks are also taken. At the beginning of this year, the ECB firmly reminded the CEOs of all major banks of the new guidelines for the leveraged finance market that had already been published in 2017. Now the message did get through to the banks and to our surprise we now see the major effect every day of it in our corporate debt advisory practice. “Normal” corporate transactions also appear to be affected by the strict new rules. We explain the reason behind this below. The key takeaways for corporates? Depending on your leverage and financing structure, you can now be confronted with (i) less room for debt financing on your balance sheet, (ii) a heavier and stricter credit process and (iii) a higher credit margin. We advise you to test the implications of the new ECB rules for your company.

A private equity fund bases its interest in a takeover of a company partly on the potential to finance a large part of the takeover sum with debt. Private equity always looks for and finds the segment of the financing market that offers the highest leverage against the most flexible conditions. The ECB published its guidelines already in May 2017 to limit banks’ exposure to this market. However, it took a stern reminder from the ECB to the CEOs of the larger banks in March this year to shake up the banks and force them into action. Now that the banks have started to actively comply with the directive, the consequences are not limited to the leveraged finance market, but also affect the ‘normal’ financing of family businesses and cooperatives.

This publication briefly explains the ECB guidelines and the consequences for corporate financing. In summary, the financing landscape for companies with a Total Debt to EBITDA ratio of 4.0x or higher is changing dramatically. We advise companies to include this new reality in a reassessment of their financing policy.

(1) European Central Bank, Guidance on leveraged transactions, May 2017

(2) Significant institutions directly supervised by the ECB. ssm.2022_letter_on_leveraged_transactions.en

What is Leveraged Finance?

Within the financing departments of banks, a distinction is made between leveraged finance on the one hand and corporate banking on the other. This distinction is based on the composition of the shareholders. A bank’s leveraged finance activities are aimed at private equity investors that are (majority) shareholders in companies. In leveraged finance, the private equity investor is the bank’s client. Corporate banking focuses on companies with a more regular shareholder base. In Corporate banking, the company is the bank’s customer regardless of the degree of leverage.

Since the financial crisis in 2008, there has been a shift in the European market for leveraged finance. After 2008, the market share of banks in larger transactions decreased significantly in favor of direct lenders and institutional investors (Term Loan B market). Direct lenders and institutional investors are winning the competition from banks because they are willing to finance a larger part of the acquisition price and apply looser covenants. Covenant-lite can even take the form that no financial covenants apply.

However, this does not mean that the role of banks in leverage finance has ended. A private equity fund that makes a takeover bid wants security of funding. Banks offer this security by acting as arranger and underwriter in the Term Loan B market. These underwriting activities are particularly risky during economic turmoil; liquidity in this market can quickly evaporate and the bank may be left with the entire financing.

(3) A transaction with a direct lender is comparable to a bank loan in terms of process and documentation (LMA). A Term Loan B is comparable to a private loan in terms of process and documentation.

(4) Implicitly, there is only one assessment moment, namely the opening leverage, or the leverage at the time the financing is provided.

(5) With an underwriting, the bank guarantees the placement, if there is insufficient interest in the market, the financing ends on the bank’s balance sheet.

(6) A recent example of this is Elon Musk’s takeover bid on Twitter, where the banks have underwritten (guaranteed) a financing package of USD 13 billion, but have not yet been able to place it in the market. According to Bloomberg calculations, the banks are now at a loss of USD 500m, due to increased risk premiums (Banks stand to lose at least $500m if they fund Elon Musk’s Twitter takeover | Elon Musk | The Guardian. October 8, 2022).

What is the ECB’s view?

The monetary policy of monetary easing, which central banks worldwide implemented after the financial crisis, has caused real interest rates to evaporate and has left institutional investors desperately looking for yield. This quest has both assured direct lenders of a large inflow of capital and has fueled the growth of the Term Loan B market. Based on a 2015 survey, the ECB finds:

The outcome of the survey highlights that globally leveraged finance markets have experienced a strong recovery since the crisis and are characterized by fierce competition. Both the appetite to underwrite a transaction and the propensity to retain parts of the exposure have grown among the significant credit institutions supervised by the ECB.

Borrower-friendly conditions have further translated into a weakening of deal structures (increased leverage levels, import of “covenant-lite” structures into European markets) and in many cases have led to greater leniency in credit institutions’ credit policies.

The ECB notes that the lending process with regard to leverage finance at many banks has room for improvement and that there are also many differences in the way banks define, record and manage these transactions. To improve this situation, the ECB published its Guidance on Leveraged Transactions in May 2017, after a consultation round.

The guidelines are not intended as a binding set of rules, but as a recommendation that banks should integrate into their internal policies. When assessing the application, the ECB looks at proportionality, there must be consistency between the size and the risk profile of the activities of the relevant bank in the leveraged finance market.

How does the ECB define a leveraged transaction?

The directive requires banks to use a single, uniform definition of a leveraged transaction (“LT”) within their organization (worldwide), whereby this definition must include all transactions that meet at least one of the following two criteria:

The borrower has an expected Total Debt to EBITDA ratio of 4.0x or higher after the financing transaction;
The borrower’s shares are owned (more than 50% shares or voting rights) by one or more private equity managers.

According to the ECB, if there is a Total Debt to EBITDA ratio of 6.0x or higher, this is a highly leveraged transaction (“HLT”).

(7) Banks may base this on the adjusted EBITDA, but “duly justified and reviewed by a function independent of the front office” applies.

The crux of the above criteria is not so much in the level of the leverage ratio, but in the definition of Total Debt:

Total Debt refers to total committed debt (including drawn and undrawn debt) and any additional debt that loan agreements may permit. … Cash should not be netted against debt.

In other words:

The usual distinction between senior debt and subordinated debt is not made. Not even if the subordinated financing does not pay interest, but the interest is paid at the end of tenor or paid in kind;
It is assumed that the committed credit lines have been drawn in full;
In addition, accordion options and baskets for permitted additional debt included in the agreement must be taken into account;
All this on a gross basis, without offsetting against the available cash.

If we calculate the Total Debt to Ebitda according to the above definition, then many companies within corporate financing suddenly fall into the category of leveraged finance. It is important to check whether the company in question falls outside the scope of the ECB’s leverage definition. The ECB makes exceptions for, among others: the public sector, SMEs, trading finance, investment grade borrowers, project financing, real estate financing and financing commodities.

(8) Almost all club deals contain an ‘accordion’. An accordion offers the possibility to ask banks to increase the credit facility. Banks do not have to participate, but they cannot prevent an increase by other banks either.

(9) All credit agreements contain a provision about additional debt that a borrower may take on in addition to the credit agreement.

What are the consequences of the Leveraged Transaction label?

If a financing is defined as LT, this has a number of consequences, which can limit the possibilities of banks to finance the company in question. The main consequences are: limited possibilities for banks to finance, a more extensive credit process and higher margins.

Limited room for banks to finance

Banks are expected to determine the available limits for LTs (leverage >4.0x) at least on an annual basis, subdivided into sub-limits according to the nature of the transaction, such as the sector in which the company to be financed is active. Exceptions to the limit and increases of the limit must be properly motivated. Transactions with a Total Debt > 6.0x EBITDA (the HLT category) may only be financed exceptionally and must again be justified.

Where maximum tickets per bank of EUR 75 million or higher are quite common for a corporate transaction, the tickets for a Leveraged Transaction will normally not exceed EUR 25 million. If we apply this to a club deal of EUR 250 million for a corporate banking client with a Total Debt above 4.0x EBITDA, which can be arranged today with 3 or 4 banks, then upon refinancing there will be a need for a syndicate of possibly 10 or more banks(!).

More extensive and stricter credit process

Banks must use a uniform credit process for all LTs. Every new transaction, but also every refinancing or amendment of an existing transaction requires an extensive analysis. An important element in this analysis is the repayment capacity. According to the ECB, there is sufficient repayment capacity if the senior debt can be fully repaid in 5 to 7 years or at least 50 percent of the total debt can be repaid.

The uniform treatment of LTs has consequences for the organization of the financing process. A corporate banker, in case his relationship qualifies as LT, must collaborate with a (partly) different internal team in a credit process that has traditionally been set up for private equity transactions. This new cooperation is not yet running smoothly at all banks, which means that it is sometimes not possible to get banks involved in transactions.

Higher rates

Traditionally, there is a big difference in rates between corporate transactions and private equity transactions. Many corporates are generally well-capitalized, have “side business” to offer, and expect attractive rates from their relationship banks. In private equity, the emphasis is often on minimal capitalization (or maximizing leverage) and borrowers are less price sensitive. From now on corporate transactions with a Total Debt above 4.0x EBITDA have to compete with a private equity transaction for the limited sub-limits available at the banks. This competition combined with the need for more banks to arrange the transaction, because of the smaller tickets, will have an upward effect on pricing.

Conclusion

The ECB’s reminder regarding compliance with the guidelines for LTs has had a major effect. The test whether a transaction meets the definition is now performed by default. The guidelines are formulated in fairly general terms, which means that in reality we see considerable differences in interpretation between the banks. In a general sense, we observe that the banks are tightening the reins after an audit by the ECB.

For corporates, such as family businesses and cooperatives, the application of the guidelines can have major consequences. If LT’s label is unavoidable, club deals with big tickets and competitive pricing are no longer available. For these companies exploring alternatives to bank financing will become a topic much sooner than before.

It is good to remember that banks should not only perform this test when refinancing, but also when increasing or extending existing financing. We advise companies to test whether the ECB definition for LT applies to them and, depending on the outcome, to translate this new reality into a financing policy that is future-proof.