Ropes & Gray Explores Implications of ECB Leveraged Finance Guidance in Real Deals Magazine
Finance partner Malcolm Hitching has authored an article published in Real Deals on June 1 2017, outlining the implications of new guidance published by the European Central Bank (ECB) to banks on the regulation of leveraged lending.
The guidance, which was published on 16 May, sets out the ECB’s expectations regarding the risk management and reporting requirements for leveraged deals and is aligned with the existing US guidance on leveraged lending published in 2013 (the US Guidance). This alignment of supervisory expectations across jurisdictions is intended to create a level playing field for banks across the key markets of Europe and the US. However, the article highlights that “some market participants in the US are now watching to see if regulatory developments under President Trump will lead to easing of the US Guidance.”
The article explains that
- The alignment of supervisory expectations across jurisdictions is intended to create a level playing field for banks across the key markets of Europe and the US. Common to both the ECB and the US Guidance are expectations that banks should not underwrite transactions with a leverage ratio of total debt to EBITDA exceeding 6.0 times (any exception would need to be justified) and that they should carry out checks to ensure that the borrower will be able to repay at least half of the total debt granted by the lenders within five to seven years.
- Key to achieving consistency is finding a common definition of “leveraged transaction”. This was broader in the ECB’s draft guidance than in the US Guidance, and the ECB has therefore sought to achieve more consistency in its final version of the guidance, although differences do still remain. In both the US and ECB Guidance, the definition of “leveraged transaction” includes all types of loan where the borrower’s post-financing level of leverage exceeds a total debt to EBITDA ratio of 4 times, but only the US Guidance defines leveraged transaction by reference to a senior debt to EBITDA ratio. In contrast, the ECB Guidance defines leveraged transactions as including all types of loans where the borrower is owned by one or more financial sponsors (a financial sponsor means an investment firm that undertakes private equity investments in and/or leveraged buy-outs of companies with the intention of exiting those investments on a medium-term basis), and this will encompass most private equity backed companies. The ECB has also amended its list of items that are excluded from the definition of leveraged transaction including bonds and loans to investment-grade borrowers (among other items). Loans classified as specialized lending (comprising project finance, real estate, object financing and commodities financing) are also out of scope.
- Greater consistency with the US Guidance has been achieved by the ECB’s decision to use adjusted EBITDA (where justified) when calculating leverage. This amendment to the draft will be welcomed by many market participants since although “creative accounting” with respect to adjustments may sometimes be conveniently used to achieve desired results, adjustments generally help standardize cash flows and reduce inconsistencies between borrowers who may treat types of income and expense differently.
- Similarly, whereas the ECB’s draft guidance was silent as to whether gross or net debt should be used for the purpose of calculating “Total Debt”, the final guidance conforms to the US position and clarifies that cash should not be netted against debt. The term “Total Debt” in the ECB Guidance now refers to total committed debt (including drawn and undrawn debt) and any additional debt that loan agreements may permit, although committed undrawn liquidity facilities are excluded.
- Whilst the final ECB Guidance has clarified a number of areas that were unclear during the consultation phase, there are still questions regarding the likely practical impact of the ECB Guidelines on the market and how stringently the ECB Guidance will be monitored and enforced. The US Guidance has resulted in lower average leverage levels and, since the European leveraged loan market traditionally has been sensitive to developments in the US, it is no surprise that many non-US financial services firms have already put in place procedures that are aligned in key areas with the US Guidance. While the leveraged lending markets in the US and Europe have demonstrated more equilibrium in recent years, a significant percentage of private equity sponsored finance transactions in Europe were levered at more than 6 times in 2016 and therefore the ECB Guidance could constrain some activities in the market.
- Non-banks and other alternative lenders are not covered directly by the ECB Guidance and some may now see increased opportunities to participate in leveraged financings to the extent that more traditional regulated lenders demonstrate more reluctance towards entering into highly leveraged loans.
- In practice, the extent to which the ECB will robustly monitor compliance with the ECB Guidance remains unclear. The ECB Guidelines remain vague as to enforcement and the resources available to European regulators are not comparable to those available to US regulators. Although the US Guidance is only guidance (not law), non-compliance with it will lead to red flags and scrutiny and there are those that question whether the US Guidance ought really to be classified as a “rule” rather than as “guidance”. The Government Accountability Office (GAO) has in fact been asked to review the US Guidance and decide whether it constitutes a rule and, if it does, it could be submitted to Congress for review. It is unclear whether Congress would undo or reject the US Guidance, although with Republican majorities in both houses of Congress and a new political environment under the Trump administration that is witnessing the rollback of “regulatory burdens” generally, the US Guidance could ultimately ease.
- The US Guidance was published in 2013 and, ever since, the ECB has actively been seeking to create a level playing field across the US and European leveraged lending markets. Perhaps, once again, European regulation will need to play catch up with the developments in the US to keep that playing field level.