Steven Davidoff Solomon writes for The New York Times, July 7, 2015
In its effort to limit leveraged loans, the government is finding once again that regulating the financial industry is like a game of Whac-a-Mole, with new unregulated players popping up to fill the risky gaps.
Leveraged lending is associated most commonly with buyouts by private equity firms, which borrow significant sums to purchase public companies. Under the calculus of such deals, more debt usually translates into greater returns for the private equity firms.
But regulators, especially after the financial crisis, have perceived this lending as risky.
Too much debt heaped on the company could cause it to collapse. More important, during the financial crisis, several banks had committed to finance more than $300 billion in leveraged loans for private equity buyouts that had been negotiated but not completed. The banks escaped having to come up with the money only because many of the deals, like those for BCE and Penn National Gaming, fell apart. If there were another crisis and the banks were stuck with similar loans, it could only bring more pain.
In 2013, the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation published guidelines outlining limits on these leveraged loans. They are the classic sort of wishy-washy standards that do not set bright lines but are so broad in wording they give regulators wide latitude to step in when they decide a leveraged loan is too risky. Even the definition of a leveraged loan is uncertain under the guidelines.
Despite the ambiguous language, one judgment is clear: Any loan above six times a company’s earnings before interest, taxes, depreciation and amortization, or Ebitda, is too risky.
But these guidelines were only that, and banks initially felt free to skirt the six-times-Ebitda rule. Instead, the banks reasoned that they could evaluate each individual loan on its own terms, allowing for more leverage if the bank thought it was acceptable. This wasn’t a problem until the last year, when the regulators started to crack down.
As far as the banks go, the regulator crackdowns made some headway. Banks began to pull back from providing private equity loans. Leveraged lending dropped 13 percent in the first half of 2015 compared with figures in the period a year earlier, according to Dealogic. Significant transactions like the buyouts of Express, Shutterfly and Tibco Software hit bumps because of an unwillingness of some lenders to back the deal, reportedly because of leverage issues.
And when banks did decide to lend, they did so at reduced leverage and were more reluctant to break the six-times-Ebitda barrier. According to Thomson Reuters, the average leveraged loan has declined to 6.3 times Ebitda this year from 6.6 times in 2014. In the third and fourth quarter of 2014, about 60 percent of buyouts exceeded the six-times figure. In the first quarter of this year, it was down to 21 percent, according to S&P Capital IQ LCD figures cited by The Wall Street Journal.
In this environment, any time a bank goes above six times Ebitda it makes news. The New York Post reported recently that Morgan Stanley was running afoul of regulators because it was financing a buyout loan for Stone Point Capital to buy Allied Insurance at 7.5 times Ebitda.
Champions of limiting leverage might cheer.
And yet, the leveraged lending guidelines are a case study in how hard it is to stamp out what are deemed risky practices and how regulation can lead to unexpected consequences.
The big winner has been unregulated financial institutions, the so-called shadow banking system. Jefferies may not be a household name, but every private equity firm has heard of it. Jefferies is an investment bank and thus not subject to the leveraged loan guidelines. In the purchase of TransFirst by Vista Equity Partners last year, Jefferies was able to finance a loan that was 7.4 times Ebitda.
And Jefferies is not shy about taking advantage of its unregulated status. It was sixth in the in the league tables for leveraged buyouts for the first half of this year, according to Dealogic, a place it never occupied a few years ago.
Needless to say, the banks are not happy and are screaming for the federal regulators to apply the rules equally to Jefferies and the business development companies.
And so a big accomplishment of the leveraged lending guidelines seems to have been transferring lending business to new players outside the strict regulatory regime for banks and deterring private equity buyouts.
Private equity firms have fretted over the loss of this source of money. It means fewer buyouts and lower returns. That, of course, may be fine unless you are a pension fund desperately relying on private equity returns to shore up your unfunded liabilities. It also has allowed strategic buyers free rein. With less competition from private equity firms, strategic buyers may be able to pay lower prices, depriving shareholders of maximum value.
All these outcomes highlight the complexities in lending. Regulation in one area may simply move the undesirable activity to another place. Meanwhile, the regulation may deter activity that can be beneficial, like private equity buyouts that help pensioners obtain a better return on their money.
It’s an incredible balance to navigate. And in the leverage lending guidelines so far, one thing is for sure: Banks are losing to the shadow banks as private equity struggles to adjust to the new normal.
Whether this is good or bad for the economy, remains to be seen.