While I have great respect for WSJ’s reporting overall, I think they got several material points wrong in a recent article on banking (“Banks Sit Out Riskier Deals – Regulatory Pressures Push Some Lenders to Let Lucrative Deals Go” 01/21/14). Based on my experience from front-line leveraged lending and my privilege of being involved with a banking-industry working group that partnered with other associations in replying to (and, where possible, helping to shape) early drafts of the Interagency Guidance on Leveraged Lending, I found the article woefully misleading on a number of fronts.
One of our firm’s major strategy initiatives is to continue efforts to educate commercial banks on why and how they remain an integral part of leveraged lending – especially into the vital middle market sector. Unfortunately, like many articles on leverage, this particular WSJ effort is not overly helpful in its discussion on the use of leverage overall, of historical facts related to banks and leveraged lending, or its interpretation of the Interagency Guidance on Leveraged Lending.
The author bases many of the points on “letters sent to about a dozen big banks” admonishing them to adhere to the guidance: “Those [leveraged lending] guidelines are designed to keep banks away from deals regulators feel are too laden with debt.” The author did not appear to have access to the letters themselves, so let’s concentrate on the guidance as published in March 2013. And for a moment, let’s put aside the underlying premise above that regulators have the time, specific knowledge, and particular insight to determine optimal deal-by-deal leverage. Indeed, the text from the guidance seems to suggest that regulators do not believe in the efficacy of a “from-on-high, one-size-fits-all” approach:
“The agencies agree that various industries have a range of acceptable leverage levels and that financial institutions should do their own analysis to define leveraged lending.” (Source: Interagency Guidelines on Leveraged Lending, March 2013)
Thus, one could argue that the regulators recognize that industry participants, themselves, have some relevant skill in underwriting leveraged transactions. More globally, let us turn to the Interagency Guidance for a hint of what the agencies think of leveraged lending writ large:
Leveraged lending is an important type of financing for national and global economies, and the U.S. financial industry plays an integral role in making credit available and syndicating that credit to investors. (Source: Interagency Guidelines on Leveraged Lending, March 2013)
I think it is wrong to imply that regulators were or are seeking banks to avoid leveraged lending full stop. They are, quite correctly, addressing how banks approach said lending – and trying to ensure there is a minimal level of capability in the underwriting and management of those types of loans. While I don’t agree with every point in the Guidance, this effort is well taken.
There also seems to be an implicit charge in the article that the big banks are singled out by these Guidelines. As popular as it might be to beat on the big banks, on the contrary, the updated guidance applies much more broadly:
“The final guidance is intended for banking organizations supervised by the agencies with substantial exposures to leveraged lending activities, including national banks, federal savings associations, state nonmember banks, state member banks, bank holding companies, and U.S. branches and agencies of foreign banking organizations.” (Source: Interagency Guidelines on Leveraged Lending, March 2013)
The WSJ article makes a major point that the aforementioned letters “demanded [that] banks comply with guidance published in March 2013 saying they should avoid financing takeover deals that involve putting debt on a company of more than six times earnings before interest, taxes, depreciation and amortization, or EBITDA…”
Poppycock! I would challenge a thorough reading of the Interagency Guidance to support that claim. This section of the article is quite misleading – if the letters say that, fine, but it would seem very inconsistent with a plain reading of the Guidance, itself. There is only one section that even mentions “six times EBITDA”. Deep in a section on guidance related to underwriting standards – and as much as a point of illustration – where the Guidance speaks to lending institutions understanding what is expected in the Credit Agreements:
Credit agreement covenant protections, including financial performance (such as debt-to- cash flow, interest coverage, or fixed charge coverage), reporting requirements, and compliance monitoring. Generally, a leverage level after planned asset sales (that is, the amount of debt that must be serviced from operating cash flow) in excess of 6X Total Debt/EBITDA raises concerns for most industries” (Source: Interagency Guidelines on Leveraged Lending, March 2013)
Where is the prohibition from the regulators? I am not in the slightest suggesting total debt of 6x EBITDA is prudent in all – even remotely most – cases. But at some point, I defer to the actual lenders (bank, non-bank, bond underwriter, etc.) that have specific knowledge of the given deal.
The article does present some data in pointing out that 27% of buyout deals in 2013 have debt-EBITDA of greater than 6x. As a recovering data geek, I’d be a bit surprised if the denominator of that ratio includes a near complete universe of all US buyouts (which is very tough to do). For example, could the data sample be skewed to larger deals with less representation from (typically lower-leveraged) middle-market transactions? Inference from a non-representative sample is inherently flawed. I submit that it is difficult, at best, to make any accurate statements about a given component as a percentage of the data universe if a material, non-heterogeneous group is underrepresented (note: middle market deals are significantly greater in terms of number of transactions, but are often significantly under-reported). I freely admit this is more a question around this specific interpretation than a fact-based criticism of the underlying data. Unfortunately, while the proximity of the data to discussion of banks might imply the Banks are the lenders in these deals – we’re not given a breakdown of this lending by types of lender (e.g. banks versus non-bank institutions). Why not?
The article continues to be self-contradictory on banks and leveraged lending:
“If banks repeatedly participate in deals regulators consider unduly risky, they would be fined or face other sanctions…” Uh, yes, that would make sense – but where is the data that banks (as in the industry, thank you) have been, or are, extreme with respect to sponsor-backed or non-sponsor leveraged lending? (…Crickets).
As if to refute itself, the article asserts “[b]uyouts aren’t seen as a big contributor to the financial crisis, and few banks suffered outsized losses from them. However, some companies laden with debt in these deals have struggled or collapsed, and many investors in their debt lost money.” Unfortunately, the reliance on vague wording like “some”, “not a big contributor”, “many” allows such assertions to be made as if fact. What banks needed to be bailed out due to private equity sponsor-backed, non-real estate loans? Let’s have fact-based debate, please.
The article is weighted to the point of view of one regulator, Mr. Martin Pfinsgraff at the OCC (actually, the only regulator quoted in the piece). Mr. Pfinsgraff makes the expected comments about addressing “bad practices” and removing “extraordinary froth that’s experienced at the peak of the market.” Absolutely fair points. We have long noted that banks are not monolithic and some are much more capable than others at maintaining discipline and level-headedness both as markets heat up – and as markets are interrupted. But as in other articles on the topics of leverage and buyouts, we’re not given any data to support a hint systemic impact from banks lending to equity-sponsor transactions. We’re forced to take these assertions as offered, on faith.
The Interagency Guidelines are readily available and not particularly long or difficult to read, but I have seen to many industry participants and pundits misinterpret them – or rely on third or fourth-hand interpretations. The successful banking institutions operating in the leveraged lending environment will be those that understand the intent of the Guidance and can show an ability to comply through establishing robust platforms that will take market share from those banks that cannot or will not compete. Leveraged lending can be managed in thoughtful and prudent manner – and (done correctly) presents signifiant opportunities for risk-adjusted returns.
Our appreciation to the WSJ for the coverage of the Guidelines, but we’d offer that a deeper look is warranted.