On 23 November 2016, the European Central Bank (“ECB”) published draft guidance on leveraged transactions (the “Guidance”) for public consultation. The consultation period will end at midnight on 27 January 2017, during which time banks, trade bodies and other interested parties may submit comments to the ECB. The Guidance follows similar guidelines which have been applicable to banks in the US since March 2013^[1].

Why Has This Guidance Been Published?

The backdrop to the Guidance is the strong recovery of the European leveraged finance markets since the financial crisis, resulting in increased competition between credit institutions for leveraged lending business and more borrower-friendly lending conditions in Europe, as shown by increased levels of indebtedness and the introduction of “covenant-lite” deal structures. The ECB is keen, therefore, to develop a clear and consistent definition of what constitutes a leveraged transaction and to rein in credit institutions’ exposures in this market.

Who Does It Apply To?

The Guidance, once finalised, will be applicable to all “significant credit institutions” supervised by the ECB^[2]. Whether an institution is significant is determined by reference to a number of criteria, but in particular its size, its importance for the economy of the EU or any Eurozone state and the significance of its cross-border activities. For example, any institution with assets exceeding €30bn will be considered significant unless justified by particular circumstances.

Although the Guidance will not have the force of law, it is difficult to see how an affected institution can escape the key supervisory aspects expected to be incorporated into credit institutions’ internal policies. The ECB expects the Guidance to be implemented consistently with “the size and risk profile of institutions’ leveraged transactions relative to their assets, earnings and capital”.

What Is a “Leveraged Transaction”?

Credit institutions should create an internal definition but transactions meeting at least one of the following criteria are to be considered “leveraged transactions”:

• Four times test: all types of loan or credit exposure where the borrower’s post-financing level of leverage exceeds a total debt to EBITDA ratio of 4.0 times; or

• Sponsor test: all types of loan or credit exposures where the borrower is owned by one or more financial sponsors.

The following types of transactions are not expected to be considered “leveraged transactions”:

• loans with natural persons, credit institutions and investment firms
• loans with a consolidated exposure for the credit institution below €5 million
• secured asset-based loans
• commercial real estate financing
• project finance loans
• trade finance.

It should be noted that although the Guidance focuses on leveraged transactions, the ECB considers that similar guidelines – in particular those that relate to underwriting and syndication – could be applied to other types of transactions where relevant.

The Proposals:

The Guidance contains several key provisions with which credit institutions will be expected to comply. In summary, institutions will be expected to:

• Underwriting and syndication: Set an overall underwriting limit and a granular set of sub-limits for the quantum and nature of leveraged transactions and assess, monitor and manage underwriting and/or settlement risks in accordance with a number of key principles outlined in the Guidance.

Key points:

• Six times: Transactions presenting a ratio of total debt (on a pro forma basis) to EBITDA exceeding 6.0 times at closing should “remain exceptional”, with any potential exception to be duly justified.
• EBITDA: Note that the ECB uses “unadjusted EBITDA” (i.e., realised EBITDA over the previous 12 months with no adjustments made for non-recurring expenses, exceptional items and other one-offs).  This is materially different to the US approach.  The US guidelines acknowledge adjustments to EBITDA and cash flow; in particular, they footnote that “cash flow” is generally projected as estimated based on performance deemed most likely to occur and provides guidance that the base case should be somewhere between the conservative and the aggressive case. Further, they also acknowledge that cash flow analysis may rely on, amongst other things, merger and acquisition synergies.  In 2015, the US regulators went further in a Q&A session and confirmed that EBITDA could be adjusted so long as reasonable support was provided for such adjustments, but observed that regulators would criticise situations where EBITDA allowed enhancements without reasonable support and noted that in some credits EBITDA calculations had included difficult to support adjustments such as unrealised savings from mergers and acquisitions.
• Total debt: In contrast to the requirements of the US guidelines, the Guidance is not explicit as to whether a gross or net measure should be applied; European practice in credit agreements is to apply a net leverage test and permit unrestricted cash to be netted off.
• Hung deals: Institutions should have a dedicated framework to deal with their hold strategy, booking, accounting practices, regulatory classification and capital requirements for “hung transactions” (i.e., those transactions which have not been syndicated within 90 days of the closing date).
• Scope: We note with interest that, in the context of monitoring and reporting syndication risk, the Guidance is expressed to apply to all transactions generating a settlement risk with specific reference (amongst others) to “best efforts” deals, including non-investment grade corporate bonds. This is in direct contrast to the US guidelines, which do not apply to bonds.
• Credit approvals: Have appropriate credit approval and due diligence processes to ensure that each leveraged transaction is aligned with their stated risk appetite. In-depth due diligence should be carried out in connection with any new leveraged transaction, and any renewal, refinancing or material modification of an existing transaction.

Key points:

• Repayable?  Ensuring that the borrower is able to repay a “significant share” of its debt (corresponding to at least 50% of the total debt granted by the institution) within a “reasonable time frame” (corresponding to five to seven years).
• Realistic?  A critical review of the business plan and projections provided by a corporate borrower or sponsor and their incorporation into the credit institution’s own “bank case” and sufficiently conservative “stress case” scenarios.
• Prudent?  Careful assessment of the transaction structure and term sheets in order to identify weak covenant features, including an absence of, or significant headroom in, financial covenants.
• Risk appetite and governance: Define their appetite and strategy for leveraged transactions as part of their internal risk appetite framework and implement governance structures which enable their senior management to exercise appropriate oversight of all of its leveraged transactions.
• Monitoring and management of holdings: Regularly monitor their leveraged transaction portfolios with “hold book” exposures reviewed at least annually with more frequent reviews for “deteriorated” exposures.
• Secondary market activities: Have policies and procedures to ensure proper adherence with regulations on market conduct.
• Reporting requirements and IT: Regularly report to their management on the leveraged transaction market and their own leveraged transactions (including any secondary market transactions), covering both transactions in the underwriting book and in the “hold book” and have information systems capable of enabling management to identify, aggregate and monitor leveraged transactions and capture all aspects of the draft Guidance.
• Audit: 18 months after the publication of the Guidance, draw up and submit to their joint supervisory team (i.e., the joint team of ECB and national supervisory staff that supervises the credit institution under the Eurozone’s Single Supervisory Mechanism) an internal audit report detailing their implementation of the Guidance.

Reflection

Deal statistics in the US show that tighter leverage constraints have led to sponsors increasing the size of their equity contributions in leveraged buyouts, which is seen as positive. However, there has been little improvement in lending terms.

Many Eurozone credit institutions are already likely to be following some, if not most, of the Guidance as a matter of good business practice. We note that in 2015 the ECB had asked banks to submit details of leveraged loans arranged and underwritten in May 2015, and it gave lenders feedback on how their portfolios compared with other banks. This move followed a similar exercise by the Bank of England in late 2014, which concluded that no action was required. We will wait to see whether or not the Bank of England will now follow in the ECB’s footsteps but if such guidance becomes regarded as the international norm then the Bank of England may follow.

Institutions that will be subject to the Guidance should now, therefore,  begin assessing their internal processes from the perspective of ensuring compliance.

We will be actively following this development and will provide analysis and insight on implications arising from the Guidance once it has been issued in final form following the consultation period.

In the meantime, please contact your usual Shearman & Sterling contact or one of the authors named below for further information.