A while ago U.S. banking regulators announced guidelines to prevent banks from making loans to companies at more than six times Ebitda, because the regulators thought those loans were too risky. More recently those regulators have announced, roughly once a week, that they intend to enforce those rules, but for real this time. Here is a Wall Street Journal story about how private-equity firms -- whose buyouts tend to be funded by leveraged loans -- are adapting to those rules. Here is one funny way to adapt:
Private-equity firms have used adjustments in their models that contribute to a company’s earnings, thereby decreasing the leverage ratio and lifting a company’s future cash flow, a measure regulators use to calculate a company’s ability to repay debt.
Vista Equity Partners adjusted Tibco Software Inc.’s Ebitda for the 12 months to Aug. 31 by 58%, to $378 million, from Tibco’s own calculation of $239 million.
This is an admirable strategy: If you want to borrow 8.5 times as much money as you make in a year, then that's bad. One way to fix that is to borrow less money, but that is no fun. Another way to fix it is to make more money, but that is hard. A third way to fix it is to cross out the number of dollars that you make in a year and write a different number, and, boom, now you are borrowing 5.3 times Ebitda.1 (Yes yes yes Vista "factored in cost savings" that the buyout would generate.)
I don't know how popular that strategy is.2
The more interesting adaptation strategy is direct syndication. The thing is, most leveraged loans don't come from banks. When a company does a leveraged loan, a bank will normally arrange the loan, and lend some of the money, but typically most of the money will come from other investors: hedge funds, mutual funds, collateralized loan obligations, etc.3 In the modern leveraged-loan market -- much like in the stock and bond markets -- banks are mostly intermediaries, matching companies that want to borrow with investors who want to lend.
Those investors can still lend. The banks can't. (I mean, they can, but the regulators will make sad faces at them.) But statistically the banks weren't lending that much anyway. They were calling up the investors who were actually lending, but banks don't have a monopoly on telephones. So:
When BC Partners Ltd. lined up financing in July to bolster the balance sheet of one of its companies, the buyout firm marketed $125 million in loans directly to investors.
After the financing, France-based Allflex had a ratio of debt to Ebitda of more than six times. The company, a maker of ID tags for livestock, earmarked the money for a potential acquisition, according to a person familiar with the deal.
In the era before the guidance, BC Partners would likely have sought the support of the banks that helped it raise $810 million in loans to fund BC Partners’ $1.3 billion purchase of Allflex.
This is not quite a story of regulation pushing these loans from banks to shadow banks. The loans were already being made by shadow banks! (I mean, funded by shadow banks. Mostly.) This is a story of regulation making the shadow-bank lending process slightly more annoying, though also slightly cheaper ("the banks didn’t get the chance to collect fees on the deal" for Allflex), by taking banks out of the middle. But the middle is generally a good place to find banks. The whole point of shadow banks is, like, they're the shadow of banks. They follow the banks around, and the banks hide stuff in them.
Here's the Financial Times back in April:
“Is it really bad that JPMorgan has a lot of people on the street trying to find loans and then a lot of people trying to find investors?” said one banker, not from JPMorgan. “That’s the essence of the US capital markets. Instead we’re going to find 100 hedge funds to go do it.”
It's weird, right? I suppose the annoyance factor might make highly leveraged deals a bit less common, but it's a weak mechanism. Financial intermediation abhors a vacuum, and, "Lenders such as Jefferies Group LLC, Nomura Holdings Inc. and Macquarie have gained market share as banks subject to the guidance have taken a more conservative approach."4 That's not, like, Jefferies (a non-bank) lending a lot of money to companies.5 That's Jefferies making a lot of phone calls to set up loans from investors, instead of JPMorgan making the same phone calls.
So the regulatory guidance doesn't particularly prevent companies from taking on too much (in the regulators' view) debt. I guess it does protect banks from being exposed to that debt, and that's something: Although a lot of leveraged-loan money comes from non-banks, a lot still comes from banks,6 and I suppose it would be rational for regulators to say that regulated banks should be more careful about making risky loans than non-banks. (There are arguments the other way: Banks may be overleveraged run-prone delicate flowers that need to be protected by regulators, but there are some pretty delicate non-banks too. Leveraged loan ETF run risk scares a lot of people.)
Anyway, the guidance about over-leveraged loans applies mostly to the origination of those loans; banks that just invest in them are subject to less scrutiny,7 which is not quite what you'd expect if the main concern is protecting banks' balance sheets rather than preventing the origination of risky loans. It's tempting to imagine a workaround where Jefferies originates highly leveraged loans, and then sells them not just to hedge funds and CLOs but also to the banks that aren't allowed to originate them.8
This guidance has always struck me as weird, an unusual instance of asset-side micromanagement of banks by regulators, and I've been amused by the banks' robust disregard of the guidance. But if they stop ignoring the rules, the result may just be to accelerate the movement of leveraged loans from banks to shadow banks, a movement that is already pretty far advanced. That doesn't seem like all that exciting a development. In theory at least, banks are informed relationship lenders that are better at monitoring their borrowers than CLOs and mutual funds are. And, in theory at least, banks are transparent to and supervised by regulators, in a way that shadow banks are not. Though I guess you can't put too much stock in that, since in this case at least the actual banks have been almost as enthusiastic as the shadow banks in ignoring the regulators.
1 Those multiples of earnings before interest, taxes, depreciation and amortization are for Tibco's 2.02 billion term loan, though the total financing is $2.97 billion through bonds. (So 12.4x or 7.9x, depending on which Ebitda you use.) The leveraged lending guidance is actually 6x for total debt to Ebitda (see page 27 of the guidance), not just for the leveraged loan itself, so Tibco doesn't seem to qualify on either version of its Ebitda.
2 It is a strange fact that Ebitda, one of the most generally accepted accounting measures in modern finance, is not actually defined by U.S. generally accepted accounting principles. And so lots of investing decisions are made on some flavor of "adjusted Ebitda," and you could imagine banks and borrowers making the case for various upward adjustments to avoid the regulatory guidance. "Examiners will criticize situations in which EBITDA is defined in loan documents in ways that allow enhancements to EBITDA without reasonable support," say the regulators.
3 Here's a 2013 Wells Capital Management note on the bank-loan market, which says that 85 percent of leveraged loans are now held by non-banks (versus 37 percent in 1998), mostly CLOs:
And here's a Davis Polk paper (PDF) on the U.S. Term Loan B market, which "is now dominated by non-traditional lenders: CLOs, hedge funds and institutional investors." Also, here is a story about how weird and antiquated the market still is.
4 But, amusingly, not in that Allflex deal: "Selling the loans directly to investors allowed the firm to get the deal done without hampering its relationship with the banks by giving the business to lenders not subject to the leverage-lending guidance." But ... how valuable is that relationship if the banks can't lend to Allflex? Hmm.
5 Jefferies is part of Leucadia National Corporation, whose financial statements show $1.6 billion in "loans and other receivables" under the category of "trading assets." So not nothing, but not even two Allflex deals worth of loans. Compare JPMorgan's $743 billion in loans, including $102 billion in its corporate and investment bank and $144 billion in its commercial bank.
6 The Fed's review of the shared national credit portfolio shows $767 billion of leveraged loan commitments from banks, though I'm not exactly sure how that accounts for syndication. But, sure, big banks do make many billions of dollars of corporate loans, and many billions of dollars of leveraged corporate loans, and even many billions of dollars of leveraged corporate loans that the Fed finds reason to criticize.
7 The 6x Ebitda guideline is in the "Underwriting Standards" of the guidance (pages 25-28), which seem to apply to the "originating institution" thinking about loans that it "will arrange." For participations in loans (pages 24-25), banks are supposed to have "appropriate risk management guidelines," but the Ebitda limit doesn't appear in that section. From the frequently asked questions:
Who is the originator of a loan for purposes of supervisory expectations under the guidance?
Institutions that arrange, underwrite, or distribute leveraged loans are considered originators. Institutions that only purchase participations in leveraged loans in the primary or secondary markets are not considered originators, but they are expected to have practices that are consistent with the guidance section on participations purchased.
Part of the reason for this distinction, incidentally, is the regulators' concern about reputational risk. Page 41 of the guidance:
Leveraged lending transactions are often syndicated through the financial and institutional markets. A financial institution’s apparent failure to meet its legal responsibilities in underwriting and distributing transactions can damage its market reputation and impair its ability to compete. Similarly, a financial institution that distributes transactions which over time have significantly higher default or loss rates and performance issues may also see its reputation damaged.
8 Don't try that at home. I feel like the regulators would dislike it intensely. On the other hand, they don't like it when banks originate over-leveraged loans while ignoring the guidance, and that keeps happening. Also, though, the banks would haaaate it.
To contact the writer of this article: Matt Levine at mlevine51@bloomberg.net.
To contact the editor responsible for this article: Zara Kessler at zkessler@bloomberg.net.
