Shearman & Sterling Discusses European Central Bank’s Leveraged Transactions Guidance

After a period of public consultation, the European Central Bank (the “ECB”) published its final Guidance on Leveraged Transactions (the “Guidance”) on May 16, 2017[1]. Twenty-four organisations (comprising credit institutions and market associations) commented directly on the ECB’s draft guidance. Most comments focused on ensuring consistency between the ECB’s Guidance and the 2013 Interagency Guidance on Leveraged Lending in the US (the “US Guidance”) and ensuring market viability in Europe. We wrote about potential issues raised by the ECB’s draft guidance in our last briefing[2]; here, we discuss the most relevant changes that made the final edit and, in addition, certain points that did not change despite representations from participants during consultation on the draft guidance. The ECB also published a feedback statement (the “Feedback Statement”), which presents an overall assessment of the comments received during the public consultation and should be referred to as a useful tool when interpreting the Guidance[3].

Who Does the Guidance Apply to?

As in the draft version, the Guidance is applicable to all “significant credit institutions” supervised by the ECB under Article 6(4) of the Single Supervisory Mechanism Regulation, each of whom is expected to adopt the Guidance as an integral part of their internal policies. The Guidance officially enters into force on 16 November 2017, after which date affected institutions will be expected to implement the supervisory and monitoring expectations set out therein. Each significant bank has a dedicated Joint Supervisory Team (“JST”), comprising staff of the ECB and national supervisors; an internal audit report should be drawn up and submitted to the relevant JST regarding implementation in November 2018.

Credit institutions which are not classified as “significant” and credit institutions based in EU member states which do not participate in the Single Supervisory Mechanism Regulation, such as the United Kingdom, are not subject to the Guidance.

Scope and Application of the Guidance

As its name suggests, the Guidance puts the spotlight on leveraged transactions. Banks are expected to define their risk appetite and governance, as well as monitor syndication risk and the fundamental credit quality of leveraged exposures. Not only that, but banks are further encouraged to apply the same supervisory expectations to other relevant (non-leveraged) transactions, which potentially widens the scope of the Guidance.

The Feedback Statement provides that while the Guidance is not binding, it will be enforced through ongoing supervision of significant credit institutions by JSTs and “dedicated on-site inspections”. The Feedback Statement clarifies that the Guidance is subject to the principle of proportionality and should be consistent with the size and risk profile of an institution’s leveraged transaction activities relative to its assets, earnings and capital.

What is a Leveraged Transaction?

As a minimum, credit institutions must treat as leveraged transactions, anything which meets at least one of the following tests:

  • Four times test: all types of loan or credit exposure where the borrower’s post-financing leverage exceeds a Total Debt to EBITDA ratio of 4.0 times; or
  • Sponsor test: all types of loan or credit exposures, regardless of the actual leverage of the transaction, where the borrower is owned by one or more financial sponsors. Ownership by a financial sponsor is deemed if the sponsor owns or controls more than 50% of the borrower’s equity.

The 4.0 times leverage test is to be calculated at the consolidated borrower level unless group financial support cannot be assumed in case the borrowing entity is experiencing financial difficulties and every deviation is to be justified and documented at the time of origination, modification or refinancing. “Fallen angels” (borrowers who have exhibited a deterioration in financial performance after loan inception) are not given special dispensation if their loan is modified, extended or refinanced. In contrast, the US Guidance makes clear that nothing therein “should be considered to discourage providing financing to borrowers engaged in work out negotiations”.

Despite requests to the ECB to remove the sponsor test due to it having no quantitative application and being out of sync with the US Guidance, this test remains unchanged from the draft guidance.

Encouragingly, the ECB has (in deviation from the draft guidance) allowed some helpful relaxations in the methods for calculating Total Debt and EBITDA.

Definition ofTotal Debt”: The definition of “Total Debt” now applies to total committed debt (including drawn and undrawn debt) and “any additional debt that loan agreements may permit”. Salient points as to the calculation of Total Debt include:

  • as defined, this will include (uncommitted) incremental or accordion facilities even if they are never actually used, which is consistent with the US Guidance. A literal reading of the Guidance further suggests that permitted debt baskets may also need to be captured in this calculation. Although the text of the Feedback Statement focuses on the presence of pre-approved additional term or revolving facilities, some ambiguity does remain on this point;
  • committed undrawn backstop liquidity facilities meeting the requirements of the Basel III liquidity standards may be excluded;
  • cash cannot be netted against debt (a new clarification which is in line with the US Guidance, but contrary to typical practice for covenant calculations in European credit agreements);
  • the ECB has confirmed in the Feedback Statement that subordinated shareholder or vendor financing and PIK instruments, even if they exhibit equity-like features, are essentially liabilities and should count towards Total Debt. Subordinated shareholder loans are often tax driven and structurally important in leveraged financings to facilitate the upstreaming of cash; and
  • debt is calculated at transaction origination using pro forma financial statements assuming the transaction has taken place.

Definition of EBITDA: Whereas the draft guidance referred to unadjusted EBITDA, the Guidance now permits enhancements to EBITDA to be made, following requests from market participants and in line with the US Guidance. Such enhancements must, however, be duly justified and reviewed by a function at the bank that is independent of the front office. This is an operational divergence from the US Guidance, which does not require such independent review. The ECB has reserved the right to look again at the issue of EBITDA enhancements, if it feels that overly optimistic adjustments with respect to pro forma “future synergies”, “future earnings” or “run-rate EBITDA” leave investors vulnerable to the next downturn in the credit default cycle.

Exemptions: The list of excepted transactions not falling within the definition of leveraged transaction has been expanded to include loans to SMEs irrespective of their amount (provided they are not owned by financial sponsors), investment grade borrowers, financial sector entities and public sector entities. Project finance and real estate, asset and commodities financing are classified as “specialised lending” and remain outside the scope of the Guidance.

In-Scope Activities

The Guidance reiterates the importance of institutions’ attention to risk appetite and governance of credit, syndication and underwriting risks of all syndicated loans (both on underwritten and best efforts basis), club deals and bilateral loans. Risk functions must have sufficient time to review all transactions and ensure that they are in line with the institutions’ respective risk appetites. The Guidance does not extend to bonds (although bonds must be included in the calculation of Total Debt). The deletion of a reference to high yield bonds with respect to the monitoring of syndication risk previously found in the draft guidance is a welcome change and is now in line with the US Guidance.

Institutions are expected to define their own acceptable leverage levels as part of their risk appetite statement. Highly leveraged transactions—those with a leverage ratio exceeding 6.0 times EBITDA—should remain “exceptional” and be “duly justified”. Although not a “bright line”, where transactions exceed approved risk thresholds or total debt is in excess of 6.0 times EBITDA, additional evidence of the involvement of senior management and the risk function is required. Deletion of a previous (harsher) requirement in the draft guidance to requiring approval from the “highest level of credit committee” allows more alignment with institutions’ own risk and governance management frameworks.

Other Key Changes

  • Budget: the requirement in the draft guidance that senior management approve an annual budget for leveraged transactions has been deleted. The Feedback Statement reports that a number of respondents had considered this to be unworkable operationally.
  • Pricing: the ECB has clarified that syndication units should perform detailed analyses to help in the pricing of leveraged loans. The price itself should be verified by a function independent of the syndication unit.
  • Repayment capacity: the ECB now defines an “adequate” repayment capacity as the ability to fully amortise senior secured debt, or repay at last 50% of a borrower’s Total Debt over a 5 – 7 year period, which is in keeping with the US Guidance. This provides for more flexibility than the draft guidance.
  • Ongoing monitoring of “hold book” exposures: the ECB has clarified that institutions are required to have clearly defined criteria to identify indicators of a borrower’s “unlikeliness to pay”. In addition, impairment tests are expected to be conducted in the event of covenant breaches, refinancings at increased leverage ratios, the refinancing of a bullet facility granted owing to financial difficulties or when it is expected that a bullet facility cannot be refinanced in current market conditions, or if there are justified concerns about a borrower’s ability to generate cash in “base case” and “stress case” conditions. In contrast, the US Guidance does not require or encourage review due to covenant breaches or expectations that a facility cannot be refinanced in current market conditions but instead apply only at the time of origination, modification, extension or refinancing.

What Has Not Changed?

  • Failed syndications / “hung transactions”: the ECB has confirmed its requirement that a transaction should be classified as a failed syndication if syndication has not been completed within a 90-day period. In practice, the ECB has arguably hardened its stance as the 90-day period is to run from the date that the institution enters into the relevant loan agreement (referred to as the “commitment date”) rather than any later “closing date” as previously set out in the draft guidance. No account is taken of circumstances in which syndication may have failed, or indeed, the syndication strategy or timetable for each particular transaction. Institutions remain expected to have a dedicated framework to deal with such transactions and to move any excess positions to the “hold book” rather than the trading book.
  • No use of proceeds or purpose test: the ECB regarded a “use of proceeds or purpose” test as a means of identifying leveraged transactions to be inconsistent with a comprehensive risk management framework. In contrast, the US Guidance includes use of proceeds as one of several factors institutions should use when defining leveraged transactions.

Reflection

Many of the comments submitted to the ECB during the consultation period centred around consistency with the US Guidance and creating a level playing field with US banks as far as the rules are concerned. Some adjustments to details in the Guidance have allowed this to happen vis-à-vis significant credit institutions affected by the Guidance. However, some would argue that fewer European banks on the whole are affected by the ECB’s Guidance compared to the US Guidance, which applies to all federally regulated banks and US branches of non-US banks and is, therefore, wider-reaching. Furthermore, in March 2017 a US congressional representative asked the US Government Accountability Office to review certain technical questions regarding the US Guidance with a view to Congress overturning or substantially changing the US Guidance. If this goes forward, the ECB’s Guidance and the US Guidance may diverge further in the future.

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 despite the US Guidance containing similar standards for the terms of leveraged transactions set out in the Guidance.

Another observation by reference to the US is that concerns have been raised in some quarters that the Office of the Comptroller of the Currency (overseeing national banks) has taken a more stringent approach to the implementation of the US Guidance than the Federal Reserve (which regulates major Wall Street banks), even though the US Guidance was issued by both bodies jointly. How each JST will apply the ECB Guidance will be seen over the coming periods, but there is certainly the possibility that divergences in approach between different JSTs may appear.

As regards non-bank lenders, the ECB does not explicitly address comments made by respondents who argued that the Guidance benefits non-bank lenders. The ECB’s justification is that the Guidance seeks to ensure sound risk management and supervisory expectations for leveraged transaction activities and does not establish absolute “non-pass thresholds” for banks when originating transactions.

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; if such guidance comes to be regarded as the international norm then the Bank of England may follow.

In the meantime, whilst many Eurozone credit institutions are already likely to be following some, if not most, of the Guidance as a matter of good business practice, institutions subject to the Guidance should now assess their internal processes from the perspective of ensuring compliance. The ECB’s explicit clarification that implementation of the Guidance should be proportionate with the size and risk profile of credit institutions’ leveraged lending businesses can give banks a limited amount of comfort. However, there are many new aspects to consider, ranging from independent functions approving highly leveraged transactions and terms that might present weak structures or protections during the life of a deal, to monitoring and managing hold book exposures and secondary market activities. The ECB expects institutions to have adequate information systems capable of enabling management to identify, aggregate and monitor leveraged transactions and capture all aspects of the Guidance within the next 18 months.

ENDNOTES

[1] The full Guidance is available at https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.leveraged_transactions_guidance_201705.en.pdf
[2] Our article on the draft guidance is available at http://www.shearman.com/en/newsinsights/publications/2016/12/ecb-publishes-guidance-on-leveraged-transactions
[3] The Feedback Statement is available at https://www.bankingsupervision.europa.eu/legalframework/publiccons/pdf/leveraged_transactions/leveraged_transactions_feedbackstatement.en.pdf

This post comes to us from Shearman & Sterling LLP. It is based on the firm’s memorandum, “ECB Publishes Final Guidance on Leveraged Transactions—What This Means for Banks,” dated May 22, 2017, and available here.