The Trump Administration Is Already Letting Big Banks Take on More RiskBy
Deals overstep recommended debt targets set out by OCC, Fed
Avantor acquisition financing leaves company 7x levered
The Trump administration is undermining guidelines for leveraged debt established to prevent a rerun of the financial crisis.
With the Treasury Department’s encouragement, Goldman Sachs Group Inc. is among underwriters arranging buyouts that skirt guidelines meant to contain excessive leverage. Deals for chemical maker Avantor Inc. and anti-virus software maker McAfee LLC sought to pile a combined $12 billion on the companies’ balance sheets, overstepping limits set out three years ago by banking regulators.
The rules were written after banks were stuck with more than $200 billion of unsellable debt in the financial crisis. The load destabilized a system already groaning under the weight of defaulted subprime consumer loans. The new deals have sparked a debate between those who credit the guidelines for reining in excesses and others, including the U.S. government, who say they are too restrictive.
“It did seem a bit arbitrary to use that metric across all industries and companies but it has moderated risk-taking over this cycle,” said Craig Russ, the co-director of the floating-rate loan group at Eaton Vance Corp. and responsible for $38.7 billion of assets.
Both sides seem to agree on one thing: enforcement is weakening. The number of leveraged buyouts at debt ratios deemed by regulators to "raise concern" has grown to 52.3 percent this year to August, surpassing the 50.7 percent set in 2007, according to data from LCD, a unit of S&P Global Market Intelligence.
The recommendations unveiled by the Office of the Comptroller of the Currency, the Federal Reserve and Federal Deposit Insurance Corp. in 2013 sought to keep companies in debt-financed buyouts shouldering no more than six times earnings before interest, tax, depreciation and amortization, a threshold that raised concern. Still, the six times ratio was meant to be a yardstick rather than an absolute ceiling, with considerations for ability to pay down debt and generate cash flow.
“The agencies do not view six times total debt divided by Ebitda as a bright line when evaluating the risk in a transaction,” said an OCC spokeswoman. “Loans to borrowers that exceed this leverage level may receive additional scrutiny to assess the sustainability of the capital structure and repayment capacity of the borrower.”
It was up to regulated banks underwriting LBOs to carry out the recommendations -- and it cost them market share. Leverage remained constrained on the biggest deals arranged by Goldman Sachs, Bank of America Corp. and Morgan Stanley even as they sacrificed business to unregulated non-bank lenders and credit funds willing to ignore the advice of regulators set out in the Interagency Guidance on Leveraged Lending.
“The primary way for arrangers to win deals is on terms and level of leverage,” said Jonathan DeSimone, managing director and chief investment officer of Bain Capital Credit’s liquid credit business.
Regulated banks on the losing end soon found a sympathetic ear in the Treasury department. In a June communique, the government told banks to “incorporate a clear but robust set of metrics when underwriting a leveraged loan instead of solely relying on a six times leverage ratio discussed in the 2013 leveraged lending guidance.” Doing so “will help maximize the role that leveraged lending plays in the provision of capital to business,” according to the Treasury.
Avantor’s borrowings will likely leave the company with a debt load in excess of seven times Ebitda “for the foreseeable future” according to Moody’s Investors Service. Goldman Sachs was lead arranger on the loan portion of Avantor’s $7.5 billion financing.
Dana Gorman, spokesman for New Mountain Capital, the private-equity firm that owns Avantor, declined to comment. Goldman Sachs spokeswoman Leslie Shribman also declined to comment. Spokesmen at TPG and Thoma Bravo, owners of McAfee, also declined to comment.
Avantor and McAfee succeeded in closing their deals by raising the return and improving covenants, under pressure from investors. McAfee also restated the leverage multiple lower. Pushback by investors was the catalyst to better terms on Avantor and McAfee, showing they may hold the key to better terms through bargaining power.
"The buyside has to be more diligent than ever," DeSimone said.
There are other elements of the framework that are going by the wayside. The guidelines are also supposed to hamper large cash-flow adjustments, weak covenants, and financial sponsors with a history of skimming off dividends soon after an acquisition.
Even though some signs of leverage are back at pre-crisis levels, such as the number of LBOs hitting or breaching six times leverage and the severe weakening of covenant protections, there are other indications that the market is sturdier now. For one, really highly levered deals above seven-times are still fairly rare -- at least for now.
"It’s not like 2007,” Russ at Eaton Vance said. “The spreads we are earning are much higher, the companies we are financing are larger and more robust.”
The jury is still out on whether the guidelines can minimize risks that may just be being shunted elsewhere. In a May report the Fed suggested that if leverage was tempered among regulated lenders, it had migrated to the shadow banking system -- a conclusion the Treasury used to proffer its case to revise the guidelines in June.
With the memories of the financial crisis fading, global growth rebounding while central banks suppress borrowing costs, a market reaching for higher yields may place a lower value on risk limits, according to Elisabeth de Fontenay, associate professor at Duke Law School, who studied the leveraged lending guidance. Regulation may be relaxing just when markets are getting overextended and need it the most, she said.
"That is always the pattern of things, when regulators pull back on regulation," de Fontenay said. "We may be in one of those moments."
Spokesmenat the FDIC and the Federal Reserve declined to comment. A spokeswoman at the U.S. Treasury did not immediately answer requests for comment.