There be monsters? Middle Market Leveraged Lending and the SNC Review

iStock_000034637758SmallSix years past the onslaught of the Great Recession, a knot of on-lookers remains committed to specters and bogeymen in the leveraged loan market. Undeterred by contrary empirical evidence and low default rates, torchbearers have tried (thus far, in vain) to enumerate any swath of banks that required rescue due to leveraged lending to commercial and industrial operating companies – in fact, not one institution’s name has come to the fore. Yet, troubled by rumors and folklore, concerned middle market professionals have nonetheless searched closets and under beds. Nary a monster. To be sure, there are examples of deals gone awry and of poor underwriting – but nothing approaching an infestation so proclaimed in full-throated voice by storytellers.

An efficient deal-making ecosystem is predicated on ready access to equity and debt capital. And if we are to be serious about debt capital formation and the craft of leveraged lending into respective market segments (be it the middle market or the broadly syndicated market), we must base our business plans, our strategies, our execution, on fact, not fantasies – on what is real, not shadows under the bed.

Recently, we were treated to a host of select sound bites from the most recent Shared National Credit Review – from which some concluded that there were, indeed, fiends afoot. But if we study the material, are there really monsters? Or shadows?

We caution that conclusions are often influenced by outdated heuristics, confirmation biases, and one’s own narrative before viewing the report. For those less familiar, the Shared National Credit Review is a well-intentioned and arduous undertaking “designed to review and assess risk in the largest and most complex credits shared by multiple financial institutions” (source: 2014 SNC review notes). Let’s repeat that for us middle market dwellers – these are large, complex, multi-investor loans. More on that later.

Report Findings
The SNC reviewers tell us that there are about $3.389 trillion of credits that they include in the universe of Shared National Credits (“SNC Universe”) in the most recent report. Of that, the regulators were able to review $975 billion of the credits – a dollar-weighted penetration of a over 28%. (See Figure 1) 

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Figure 1

Reviewing credits is demanding work and we applaud the effort that goes into the program. However, one needs to be more than careful when extrapolating insights from a given sample to the overall (SNC) population in the best of cases. This is complicated by the heterogeneity of the SNC Universe – that includes investment grade, institutional loans to fallen angels; from $25 million middle market club deals to the multi-billion dollar liquid, broadly syndicated facilities; and includes the subset of deals that were bad deals at origination (on the latter point, and to be clear, we do not suggest, nor believe, that all leveraged loan underwriters are homogeneous in skill; in fact, our experience in working on syndicates and on deals with scores of banks and non-banks supports exactly the opposite).

We have heard for some time that the regulators were not pleased with certain banks and their underwriting processes – and there was a considerable desire to make an example of leveraged lending practices. Peeling the onion a bit on the SNC review shows that the sample of credits for selected review was, indeed, largely targeted at leveraged lending. For although leveraged loans made up less that 23% of the SNC Universe, these loans were 64% (dollar weighted) of loans reviewed. (As a further complication: there is no universal definition of “leveraged loan” – even as the regulators note – so care in this characterization is also warranted).

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Figure 2

We quibble not with the selection or focus of the review sample – and note that the regulators specify a bias in the sample, themselves:

The sample was weighted toward noninvestment grade and criticized credits with 89.3 percent of all special mention and classified credits reviewed. [See SNC report, page 4]

But if the sample is biased significantly toward leveraged loans and toward criticized assets, take great care in attempting to interpret statistics for anything beyond description of the specific sample (e.g. drawing fallacious conclusions about the population of loans based on a skewed sample). Again, we understand the effort to home in on key credit types and commonality of factors that appear to be attributes of certain class of assets (e.g. appropriateness of underwriting techniques in criticized deals).

That said, and in no way negating the validity of the analysis of the sample, we argue that it is unreasonable to unwittingly extrapolate a rate of incidence of a given factor in the review sample – say, relative strength underwriting of criticized credits – to make generalizations to leveraged lending writ large – especially onto a heterogeneous population so materially different from the sample as we will discuss in a later note.

This, then, is a critique not of the SNC report, itself. Rather, it is a caution related to extrapolating its findings inappropriately. As an example, we have noted before that the middle market makes up a disproportionate share of numbers of sponsor-backed transactions – and while the demarcation of middle market and broadly syndicated markets may blur – deal structure, including debt, are materially different across those sectors.

So, if you are stuck gathered around a campfire, listening to storytellers’ tales of woe and carnage in the leveraged lending market, drink your cocoa knowing your hearing a legend – based loosely on select facts, but largely embellished for effect.

In part two of this series, we will be looking more deeply at the SNC review results. In part three, we’ll be illustrating how removed the SNC Review’s leveraged lending sample is from typical middle market deals.

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