Words matter. This is proving especially true for the European Central Bank and the financial institutions it regulates.
Towards the end of last year, the ECB kicked off a consultation on leveraged loan transactions with a set of guidelines. They included a proposal for a standardised definition of EBITDA across European banks, as well as a push for higher standards of internal monitoring of existing loans and better due diligence assessments.
The guidelines said that leverage ratios of 6x “should remain exceptional” and be immediately referred to the highest internal body on credit decisions.
On the surface, the suggestions are sensible. But some say the definition of what constitutes leveraged finance is not clear enough. According to the ECB, a leveraged transaction is “all types of loan or credit exposure where … leverage exceeds a total debt to EBITDA ratio of four times”.
A note published by accountancy firm KPMG says this may result in banks having to reclassify what they consider to be standard corporate loans as leveraged transactions. Additional monitoring measures are now likely to apply to such loans, further burdening the banks.
Commentators have noted that the ECB’s recommendations are similar to those introduced in the US three years ago. While these are not necessarily the final rules (consultation is due to end on 27 January), it does outline the thinking of European regulators in wanting to see more alternative sources of capital enter the European mid-market lending space.
A recent analysis piece by Reuters points to alternative lenders being the winners if the guidelines are ushered in, driving “riskier LBOs underground” and into unregulated channels as regulated institutions are forced to pass on highly levered transactions if the guidelines come into force.
This could fuel the trend for sponsors to turn to debt funds for acquisitions. “The private placement of junior debt in LBOs has been a feature of the market for many years,” says Tom Maughan, managing director at Bain Capital Credit. “This regulation should add to that trend and it will be interesting to see how the EBITDA definition in particular is implemented in practice. Private equity firms like to understand the cost, flexibility and speed of their financing options, which include underwritten liquid and private debt structures.”
He continues: “The LBO market has evolved over the last decade for both private credit funds and debt advisors to facilitate these options.”
Debt fund managers are often quick to dispel any notion that they are in competition with banks. Deal origination teams at banks are much larger and have greater flexibility to write off underperforming loans should the worst happen.
But it’s clear that the private debt market has benefitted enormously from regulations placed on banks following the global financial crisis. The latest proposals from the ECB certainly have the potential to aid that trend.