Leveraged Lending: Evolution, Growth and Heightened Risk

The interagency Shared National Introduction Credit (SNC) Program is conducted twice each year and is a primary Leveraged lending provides credit to mechanism for the FBAs to monitor commercial businesses with higher leveraged lending in IDIs related to levels of debt and also helps companies portfolio growth, underwriting trends, obtain funding for transactions and risk management practices. involving leveraged buyouts (LBOs), A SNC is defined as a loan greater mergers and acquisitions (M&A), than $100 million made by three or business recapitalizations, and more institutions, which includes business expansions. Many commercial various types of loans, in addition to businesses successfully utilize and leveraged loans. The FBAs publish repay these loans; however, high annual results of the combined semi- debt levels coupled with lower levels annual SNC review, which includes of liquidity may reduce businesses’ details on leveraged lending trends flexibility to respond to changes in and associated risks. The FBAs also economic conditions. The recent conduct targeted examinations of period of economic expansion leveraged lending activity in addition combined with low interest rates to ongoing supervision to assess risk provided companies with the in this area. opportunity to increase their debt levels over the past decade. As a result, Both bank and non-bank entities are more businesses sought, and received, involved in leveraged debt financing. leveraged loans. Banks held approximately 63 percent of leveraged loan commitments in The FDIC recognizes the important the SNC portfolio as of December 31, role that leveraged lending has 2018, compared to 37 percent held in the global market economy, as by non-banks. This article focuses well as the important role insured primarily on exposure in the banking depository institutions (IDIs) serve sector, and the content is based in providing credit to companies on observations from SNC results through originating and participating and examination findings at FDIC- in leveraged loans. Underwriting and supervised IDIs. bank risk-management practices are expected to be commensurate with the potential heightened risk associated Leveraged Lending Defined with this type of lending, and IDIs and the leveraged-lending market as a Leveraged lending has no universal whole benefit from the origination of definition and is not defined in soundly underwritten loans.1 exact terms by regulatory agencies. Supervisory guidance establishes a The FDIC and other Federal range of potential criteria,2 and IDIs Regulatory Banking Agencies (FBAs) generally consider overall borrower closely monitor industry leverage risk, loan pricing, and measures trends, and banks’ underlying risk- of leverage (in terms of debt to management practices associated with income) when defining leveraged this type of lending. credits within bank policies. Credit

1 See, e.g., the Interagency Safety and Soundness Standards in Appendix A of Part 364 of the FDIC’s Rules and Regulations, and the risk management practices outlined in the Interagency Guidance on Leveraged Lending.

2 https://www.fdic.gov/news/news/financial/2013/fil13013.pdf.

10 Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION rating agencies typically define weaknesses in this sector.3 Since leveraged lending as loans rated then, risk management practices below investment grade level, which have improved significantly at most is categorized as Moody’s Ba3 and IDIs involved in structuring and Standard & Poor’s BB-, or lower, and underwriting leveraged transactions. for loans to non-rated companies that However, credit structures themselves have higher interest rates than typical have continued to weaken reflecting loan interest rates. heightened demand for leveraged credit and non-bank preferences on The SNC program tracks leveraged terms. Findings from the 2018 SNC lending based on information reported review,4 state that “many leveraged by IDIs, and therefore accurate loan transactions possess weakened reporting by institutions is critical. transaction structures and increased As disclosed in the January 2019 reliance upon revenue growth or SNC public statement, bank-reported anticipated cost savings and synergies leveraged credits in 2018 totaled to support borrower repayment approximately $2.1 trillion, of which capacity.” IDIs purchasing leveraged $700 billion was investment grade. loans should be fully aware of the risk This level is consistent with the and possess the skills to measure, leveraged loan market size noted by monitor, and control it.5 the rating agencies at $1.2 to 1.3 trillion, which excludes investment The increased risk in leveraged grade lending is illustrated in the volume of leveraged loans that are listed for Special Mention6 or subject to Leveraged Lending Risk adverse classification by the FBAs. Of the $295 billion in Special Mention Results from SNC reviews have and adversely classified loans within highlighted building risk in terms of the total $4.4 trillion SNC portfolio, dollar volume and loan structures. leveraged loans comprise 73 percent In 2014, the FBAs issued a “Leverage of special mention commitments, 87 Lending Supplement” that highlighted percent of substandard7 commitments, underwriting and risk management 45 percent of doubtful8 commitments,

3 https://www.fdic.gov/news/news/press/2014/pr14096.html.

4 https://www.fdic.gov/news/news/press/2019/pr19004a.pdf.

5 The Interagency Safety and Soundness Standards in Appendix A of Part 364 of the FDIC’s Rules and Regulations, as required by Section 39 of the Federal Deposit Insurance Act, addresses the importance of prudent credit underwriting, loan documentation requirements, and asset quality controls and monitoring practices. In addition, IDIs engaged in leveraged lending should be aware of the risk management practices outlined in the Interagency Guidance on Leveraged Lending.

6 Special mention commitments have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses could result in further deterioration of the repayment prospects, or in the institution’s credit position in the future. Special mention commitments are not adversely rated and do not expose institutions to sufficient risk to warrant adverse rating.

7 Substandard commitments are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard commitments have well-defined weaknesses that jeopardize the liquidation of the debt and present the distinct possibility that the institution will sustain some loss if deficiencies are not corrected.

8 Doubtful commitments have all the weaknesses of commitments classified substandard and when the weaknesses make collection or liquidation in full, on the basis of available current information, highly questionable or improbable.

11 Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION Leveraged Lending continued from pg. 11

and 76 percent of non-accrual9 loans. lenders have become more involved in A material downturn in the economy originating and syndicating leveraged could result in a significant increase in loans in recent years. classified exposures and higher losses.

Non-bank investors in leveraged Effective Risk Management loans are primarily collateralized loan obligations (CLOs), pension The Interagency Guidelines funds, exchange-traded funds (ETFs), Establishing Standards for Safety and and managed funds. These entities Soundness10 (Guidelines) outline the have increased their participation standards the FDIC uses to identify in the leveraged-lending market and address potential safety and via purchases of loans or direct soundness concerns and ensure action underwriting and syndication of is taken to address those concerns exposure and more leveraged lending before they pose a risk to the Deposit risk is being transferred to these Insurance Fund. The Guidelines set entities. This trend and heightened forth a framework for appropriate risk competition have caused a shift from management that can be applied to traditional IDI loan structures. In leveraged lending based on the size of order to satisfy investment demands, the institution and the nature, scope banks began to structure leveraged and risk of its activities. lending products that more closely resemble a bond than a corporate Among other expectations, the loan. For example, leveraged term- Guidelines state that an institution loans carry few if any financial- should have: maintenance covenants. Additionally, these loans often require only „„ internal controls and information minimal debt amortization, which systems that provide for effective underscores that the likely repayment risk assessment; timely and source is debt refinance. accurate financial, operational, and regulatory reports; and adequate Large IDIs that syndicate and arrange procedures to safeguard and manage a majority of the leveraged loans assets; hold few if any of these term-loan „„ loan documentation practices that facilities on their books, but often enable the institution to make provide funding for the revolving- an informed lending decision credit facilities. A revolving credit and to assess risk, as necessary, facility provides the borrower with the on an ongoing basis; identify the flexibility to draw down, repay, and purpose of a loan and the source withdraw again. During an allotted of repayment, and assess the period of time, the facility allows the ability of the borrower to repay borrower to repay the loan or take the indebtedness in a timely it out again. While IDIs traditionally manner; demonstrate appropriate arrange and distribute leveraged loans, administration and monitoring of a and serve as administrative agents loan; and take account of the size for those loans, non-bank direct and complexity of a loan;

9 Nonaccrual loans are defined for regulatory reporting purposes as loans and lease-financing receivables that are required to be reported on a nonaccrual basis because (a) they are maintained on a cash basis owing to a deterioration in the financial position of the borrower, (b) payment in full of interest or principal is not expected, or (c) principal or interest has been in default for 90 days or longer, unless the obligation is both well secured and in the process of collection.

10 https://www.fdic.gov/regulations/laws/rules/2000-8600.html.

12 Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION „„ prudent credit-underwriting practices that are commensurate Underwriting Trends with the types of loans the institution will make and that In accordance with the Guidelines, consider the terms and conditions IDIs are expected to develop policies under which they will be made; and procedures that identify and consider the nature of the markets measure risk, monitor leveraged in which loans will be made; provide credit, and implement sound for consideration, prior to credit underwriting and risk management commitment, of the borrower’s practices. As mentioned, leveraged overall financial condition loan volume has increased and loan and resources, the financial structures have weakened. This trend responsibility of any guarantor, the has, in part, been driven by increased nature and value of any underlying competition for such products, as well collateral, and the borrower’s as by the increasing fees generated character and willingness to repay by originating these credits. as agreed; establish a system of Examination data shows that some independent, ongoing credit review IDIs have purchased participations and appropriate communication to in leveraged loans without fully management and to the board of assessing the risk or developing directors; take adequate account appropriate policies and procedures. of concentration of credit risk; and are appropriate to the size of the In recent years, lenders have allowed institution and the nature and scope covenant protections to erode. of its activities; and This trend results in fewer lender protections. This point is illustrated „„ a system to identify problem assets by Moody’s in its Loan Covenant and prevent deterioration in those Quality Indicator (LCQI) graph of assets; conduct periodic asset- newly originated leveraged loans as quality reviews to identify problem noted in Moody’s Investors Service assets; and provide periodic asset press release dated April 24, 2019. and reports with adequate information is supported by published findings of for management and the board annual SNC reviews. of directors to assess the level of asset risk. Since 2012, Moody’s has tracked Risk management programs for IDIs the quality of covenants in newly that originate or arrange leveraged originated loans for the quality loans or participate in a large volume of financial covenants, structural of leveraged loans should be more fully priority, restrictive payments, debt developed and comprehensive versus issuance, investment and asset IDIs whose leveraged lending activities sales, and general lender rights. The are limited in volume and size relative graph illustrates the weaker trend of to its overall capital and reserves. covenant protection since 2016, which highlights the risk faced by IDIs lending to leveraged borrowers.

13 Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION Leveraged Lending continued from pg. 13

As mentioned previously, the 2018 interest payments or payment- SNC review found that leveraged loan in-kind (PIK). Junior debt has transactions possessed weakened historically provided additional transaction structures that may limit protection to senior secured lenders; borrower repayment capacity, and however, the protection has declined by extension, cause losses at IDIs. in recent years, as more leveraged- These weaknesses are discussed loan transactions contain only first more fully below. lien senior secured debt in the capital structure.

Capital Structure and Lender This trend implies greater reliance Priority on lender protections, which include Leveraged borrowers use a the value of the entity as a going variety of debt and equity to fund concern, the value and quality of acquisitions, asset purchases, collateral, support from sponsors and dividends, and refinancing guarantors, and covenant protections. transactions. IDIs typically provide Most leveraged loans are secured all of the first lien senior secured by all business assets and common revolving lines of credit as well as stock of the company (Enterprise some of the first lien senior secured Value), which results in valuing term loans in leveraged transactions. the company based on its ability As mentioned, leveraged first to generate recurring cash flow. lien term loans may have limited Accordingly, the value of a company amortization requirements. Junior can rapidly fluctuate. Examinations debt facilities typically require no have identified instances in which amortization. IDIs failed to adequately monitor enterprise value, or where enterprise The capital structure may also valuation methodologies were include junior debt such as senior inadequate. Failure to monitor this secured bonds, subordinated lender protection could result in mezzanine debt, or other hybrid insufficient reserves in the event of equity facilities that only require borrower default.

on ovennt uity sores

Sores er verge eesteve rotetion hresho eeve rotetion hresho

Stronger

Weaker

Source: Moody’s Investors Service

14 Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION Repayment Capacity and can affect repayment and refinancing risk. Recent examples Effective analysis of a leveraged include companies that have used borrower’s debt repayment capacity these “carve-outs” from the collateral can be challenging due to the complex pool to move business lines and capital structures and rapid growth intellectual properties to affiliates of strategies that are typical in leveraged the borrower, which resulted in lower lending. IDIs develop models and potential borrower enterprise value. analyze repayment capacity using cash flow assumptions developed by Leveraged-loan credit agreements the borrower or sponsor. Examiners often require a certain agreed-upon carefully scrutinize assumptions amount of excess cash to be used to promoting overly aggressive EBITDA pay debt, but carve-out provisions add-backs that do not reflect a ‘most in recent credit agreements often likely’ scenario in IDI repayment allow cash to be used for dividends, models, and have identified instances investments, capital expenditures, and in which repayment modeling is not other purposes before being included well supported or overly aggressive. in the excess cash flow calculation that is used to determine the amount Credit Agreement Protections for debt repayment.

The loosening of terms within credit Examiners have identified cases of agreements in recent years presents limited identification and assessment a heightened level of risk for IDIs. For of these types of underwriting and example, many credit agreements credit agreement weaknesses, which allow borrowers the right to obtain can minimize the efficacy of credit additional debt without the current risk grading, understanding of portfolio lender’s approval, an ability known as risk, and appropriateness of loan and incremental facilities. The additional lease loss reserves. incremental debt can result in elevated leverage and dilute collateral protection. Loan Review An effective loan review structure Financial-maintenance covenants serves to mitigate leveraged-lending are also becoming rare in leveraged- risk, and given the complexities and loan structures. Financial- risk inherent within a leveraged-loan maintenance covenants play a vital portfolio, the scope and independence role as an early warning sign of of the process is critical. A common deterioration in a leveraged borrower. scope may include consideration For many newly originated leveraged- of the reasonableness of cash flow loan transactions, protection consists projection assumptions, adequacy of of “springing” covenants that limit loan stress testing, compliance with the use of revolving credit facilities covenants, adequacy of enterprise only after the revolver is drawn to a valuations, and ultimately the specified level. accuracy of the credit rating. Leveraged-loan credit agreements Examinations have identified are also structured to allow a instances in which loan review borrower the ability to sell, transfer, frequency, depth, and quality has and purchase assets in the normal been insufficient to provide a strong course of typical operations, which independent assessment of credit can expose lenders and investors to administration and underwriting reduced cash and collateral protection

15 Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION Leveraged Lending continued from pg. 15

relative to leveraged lending. Further, Management and Board in some other instances, loan review Oversight staff or outsourced loan review personnel were not trained to assess The establishment of effective the unique credit characteristics of risk tolerance, measurement, and leveraged borrowers. reporting is critical. Examinations have identified instances in which policies and procedures do not have Syndications, Participations, and clear portfolio and capital limits on Sub-Participations the volume and type of leveraged credits, including limits to any single Leveraged loans can be purchased leveraged borrower. Examinations directly from agent banks or have also identified instances in indirectly through third parties which policies and procedures are such as bankers’ banks or non-bank inadequate in terms of monitoring financial institutions. Third-party and risk-ranking leveraged credits. providers can provide smaller investment amounts for IDIs, as well as provide other fee-based services. Third-party providers can also assist Summary with the risk management function, Leveraged lending presents generally for a fee, which can include heightened risk for IDIs if internal help with underwriting, risk rating, risk management programs are not enterprise valuations, and ongoing established and effectively managed. credit review. Leveraged lending volumes, held by banks and non-banks, have continued Outsourcing any risk management to increase. As a result, regulatory function comes with risk, and scrutiny of this sector will continue. examinations have identified situations where IDIs have become overly reliant on the vendor. IDIs Gary L. Storck are expected to maintain sound Senior Large Financial vendor management programs Institution Specialist when purchasing leveraged loans Division of Risk Management from a third party, which includes Supervision independent analysis of each credit. [email protected] Mark D. Sheely Senior Large Financial Institution Specialist Division of Risk Management Supervision [email protected]

16 Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION