February 9, 2017 - While U.S. lenders – and borrowers – wonder whether the financial regulatory system may quickly ease under President Trump, the reality is that regulatory changes may take time to come to fruition, as noted here and here last week. At the same time that U.S. participants hope for easing, European lenders may fear the imposition of greater restrictions. As previously reported, in November, the European Central Bank (ECB) published draft guidance on leveraged transactions (“Draft Guidance”). Seen merely as a matter of time by some, particularly institutions who have active U.S. loan businesses, other institutions regulated by the ECB were taken by surprise. Moreover, while U.S. banks bemoan the complexities and constraints of the U.S. Leveraged Lending Guidance (“U.S. Guidance”), the European Draft Guidance appears stricter in several respects. Below, we discuss the European Draft Guidance, as well as some industry comments.
The Draft Guidance would be applicable to all “significant credit institutions” supervised by the ECB under the Single Supervisory Mechanism (“SSM”), but would not apply to nonbank lenders. In 2016, banks subject to the Guidance held approximately 82% of the banking assets in the Eurozone. The Draft Guidance largely follows the principles of the U.S. Guidance. To wit, banks are expected to consider in their definition of leveraged transactions those loans or credit exposures where the borrower’s post-financing level of total leverage exceeds 4x EBITDA and/or where a borrower is 50% owned by a financial sponsor. Transactions in excess of 6x total debt to EBITDA ratio should remain exceptional and raise concern for most industries, and internal due diligence systems should flag any structures presenting weak covenant features, such as the absence of, or where there is significant headroom in, financial covenants. A borrower should show the cash-flow ability to repay at least half of its total debt in five to seven years. Finally, the Draft Guidance is guidance. Its principles should be adopted in banks’ policies, but it is unclear if the ECB will apply the Guidance as a rule (like in the U.S.). The effect, however, may be felt greater in Europe where banks represent a significant share of the leveraged credit markets and leveraged credit investors rely more heavily on supply from PE financial sponsors.
Moreover, there are several key differences between the two regimes, highlighted in industry comments submitted at the end of January, which would be unwelcome in Europe. For instance, the Draft Guidance speaks only of total debt rather than including a 3x senior debt leverage test. Also, the U.S. Guidance is explicit that it should not restrict financing to borrowers in restructuring and workout situations, but the Draft Guidance is silent. Critically, the Draft Guidance refers to “unadjusted EBITDA”. The U.S. Guidance uses adjusted calculations which permit some assumptions – more in line with how financing businesses operate. That being said, EBITDA addbacks are receiving increasing scrutiny by U.S. regulators with a couple of late 2016 deals not passing regulatory muster due to generous addbacks. Hopefully, the ECB will hear the concerns raised by market participants and those comments will be reflected in the final guidance. But that remains to be seen.