ECB increases scrutiny of European leveraged finance market

The European Central Bank has increased its focus on leveraged finance arrangers in Europe, with the organization scrutinizing the amount of risk banks are taking, and threatening to impose capital add-ons to those banks deemed to have insufficiently strong risk-control measures.

“Regulators have been almost living in the offices of some French banks,” comments one banking source. “They have been increasingly asking about levels of exposure to loans and CLOs.” Sources add that banks are mindful of this scrutiny, and in some instances are turning down requests for funds to invest in CLOs because of the heavy monitoring.

The potential introduction of capital add-ons, as flagged by the Financial Times earlier last week, was confirmed by sources that LCD spoke with. “Where banks incur risks in leveraged lending that are not adequately addressed by appropriate risk-management practices, ECB banking supervision is considering supervisory actions and measures, including qualitative or quantitative requirements as well as capital add-ons,” said an ECB spokesperson.

What remains unclear is how the ECB intends to act on its threat of imposing such measures, and how much bite they would have.

Capital add-ons can be imposed in different ways depending on the circumstances, but when they will be applied, and whether they would be compulsory or not, remains uncertain. If they can be enacted as part of the ECB's “Pillar 2 Requirements” then they are legally binding, but under its “Pillar 2 Guidelines”, they are not binding. And should such measures fall under the Pillar 2 Requirements then it would potentially be transformative for the market, while under the Pillar 2 Guidelines they would elicit greater scrutiny and focus, but ultimately have less impact.

The feeling among leveraged finance market participants is that proposed capital add-ons would likely come under the Pillar 2 Guidelines, thereby making it easier for banks to rebuff sanctions. But if certain bank behaviors — such as offering rising leverage multiples above 6x, above the threshold as defined by the leveraged lending guidelines set out by the ECB in 2017 — were not to change, then the ECB might look to add more bite.

Cov-lite issuance dominates
Since the leveraged lending guidelines were put in place in 2017, general monitoring and exchange with the banks has been common practice. However, in recent times the pressure to monitor the guidelines and how they are being implemented has risen — partially because cov-lite issuance continues to dominate the leveraged finance market, while leverage multiples remain elevated. ECB regulators are therefore concerned that these trends are increasing, and there is praise from some market participants for the increased scrutiny, as opposed to the ECB potentially acting too late.

Certainly cov-lite issuance is ubiquitous, accounting for a record 94% of European institutional loan volume in 2020, up from a 51% share in 2015. However, a lack of maintenance covenants (a set test, typically on leverage each quarter) has made loan lending more commercially viable, and has yet to create the gremlins that were so feared during its advent. If anything, cov-lite has been a big help to companies during the pandemic crisis, allowing them to remove the bureaucratic headache of requesting waivers that would have certainly been given due to the challenging backdrop. That said, a key issue for consideration is how cov-lite will impact debt recoveries should defaults rise, with a report from S&P Global Ratings in October 2020 (looking at the U.S. market) highlighting that cov-lite loans realized average and median recovery rates that were 11% and 34%, respectively, below those realized by non-cov-lite loans.

“There is no doubt leverage is rising across some names as a direct result of the current crisis,” says a fund manager. “I do not like valuations and I do not like how much debt is being put on names. For now, liquidity is so abundant that it is less of a concern, but a few years down the line we might be staring at a far higher default rate.”

Moreover, concerns are frequently expressed over how leverage multiples have been artificially reduced due to perceived egregious adjustments, while covenant protection has been significantly eroded — though this is different from the issue of cov-lite supply.

Indeed, EBITDA adjustments — whereby companies adjust for things such as expected synergies, or supposedly one-off losses of income — are keeping a lid on average leverage numbers, and perhaps of greatest concern is the proportion of deals levered between 5x-5.9x. Market sources often comment that once adjustments are taken out, leverage can rise between a half to a full turn, and therefore many of the 5x-5.9x cohort may in reality be levered at more than 6x. Indeed, the 5x-5.9x bracket was up at 34% of all European leveraged loan deals in 2020, and only once since 2006 has this measure been higher (at 35%, as recently as 2018).

A question of timing
While there are good reasons for the closer scrutiny, and all agree it is only right and proper for the ECB to track developments in leveraged finance, there is some bemusement regarding the timing, with some market participants noting it is precisely because of the gargantuan amounts of money the ECB has poured into financial markets that leveraged finance is accused of being frothy, as such support has driven down yields, forcing more money down to the lower regions of the credit ratings ladder.

It might be an unintended and unwanted consequence that merits scrutiny, but ECB action has therefore contributed to this increased demand, leading investors to actively ask banks for riskier deals in order to generate yield. “Only this morning, I had a couple of separate accounts asking me when we were going to bring PIK deals,” comments a head of leveraged finance. “They were asking why there aren't more dividend deals too. They want yield.”

Moreover, arrangers point to larger equity checks than has been the case for years amid a clear increase in private equity sponsor support, and to question marks around how much leverage has actually increased.

According to LCD data, the average equity contribution for a Europe-only LBO last year was the highest it has been for at least a decade, at 57.4%, and significantly higher than the average 48.4% contribution for the 2011-20 period. Moreover, sponsors were widely praised last year for standing behind their portfolio companies and providing greater support.

Meanwhile, total leverage for double- and single-Bs only edged higher year-on-year in 2020, and was not even at the highest it has been in the last 10 years. Indeed, the 2020 leverage multiples of 4.2x for double-Bs and 5.5x for single-Bs were higher in 2017 for the former cohort, and 2018 for the latter.

That said, the percentage of deals levered at 6x or more remains elevated, at 29% in 2020, with this measure only being higher once since the eye-watering 51% share hit in 2007, when it reached 31% in 2018. The average on this measure in the last three years is 29%.

Risk management
The buy-side is also generally of the view that risks in the market are well-known, and question whether they really need saving from themselves. They are, after all, meant to be sophisticated investors, capable of analyzing risk. “The truth is that the market knows what it's buying,” states a buy-sider. “We're not just looking at the public EBITDA levels and making a decision based on that, we're all grownups. It's still surprising that we're back where we're at [in terms of current low pricing and high leverage] but given the market technical, it's where we are now.”

The flipside though is that it is not too hard to find comments about how some investors do not do sufficient credit work, let alone fully understand what the weak covenants on some deals allow for, and are instead driven by relative value and a belief they can simply trade out of a name that goes wrong.

Sources also point out that capital markets are providing a crucial function at present, raising much needed liquidity for companies forced into little revenue generation through social lockdown measures. If companies are unable to generate revenues and yet need to take on debt to navigate the lockdown, it stands to reason that leverage will rise. Given the ECB needs the banks to help aid lending, then penalizing them when they are in effect helping to stop companies from going to the wall en masse could therefore be argued to be unfair, sources comment.

As mentioned above, this is not the first time there has been scrutiny on leverage levels, with the ECB having previously produced guidelines around deals not being levered at more than 6x. The Federal Reserve Bank had similar restrictions in the U.S. for some time, and the Fed did make a difference for a while as its requirements were perceived to have teeth.

Regardless of how much bite any guidelines have, there is also frustration that this focus is now on European banks alone, with some sources at the banks asking for a level playing field. There is also the unintended consequence of driving more business to direct lenders, who do not face as much scrutiny from the ECB, and therefore are able to offer even higher levels of leverage. “A proposed financing is out at the moment for 8x leverage, a yield with a six-handle, and extremely loose covenants,” comments a banker. “Direct lenders can be much more creative than we can.”

Buysiders also question the 6x threshold, which they view as arbitrary — arguing that it is not companies going above 6x that is a concern per se, but rather a weaker company levering up to 5x, for example, when it can only really take four turns of leverage. It is mostly the bigger and stronger companies that go above 6x, and they have a history of deleveraging.

Indeed, Verisure AS this month sold triple-C unsecured bonds at 5.25% and has total net leverage of 7x, while also extracting a €1.6 billion dividend, so if ever there was a deal that could be said to have tested the spirit of the guidelines, then this was it. And yet for the last five years the company has delevered and then relevered, taking out a total of €3 billion of dividends in that time. And if any evidence was needed of demand for such a credit, which has strong free cash flow generation and a sticky subscriber base, those bonds quickly soared to 103 in the secondary market.