Banks Search for Loopholes in Leveraged Loan Guidelines

Wall Street banks are playing cat-and-mouse with US regulators over rules that seek to reduce lending for deals that load up companies with too much debt, as they try to retain a profitable business and meet demands from clients and investors.

Leveraged lending is one of the most lucrative forms of loans for banks, giving Wall Street an incentive to accommodate borrowers as much as it can. Banks fees on US junk-rated loans stand at $4.9 billion so far this year, a year-to-date record and up 10 per cent from the same period last year, according to Thomson Reuters and Freeman Consulting data.

The guidelines, issued by the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp in March last year, generally seek to restrict banks making loans in deals such as leveraged buyouts that would leave a company with debt levels that are more than six times its annual cash flow.

Since the guidelines were issued, regulators have warned lending standards have in fact deteriorated.

As a result, banks are exploring whether they can arrange more of special kinds of bonds for companies that should not be taking on more loans under the guidelines, according to banking sources who spoke on condition that neither they nor the banks they work for or with are identified.

These bonds would help to split the overall debt load between a holding company and its operating subsidiary. The guidelines are aimed at curbing risky loans and do not directly address bonds.

"There are a lot of smart, creative people out there that are looking for ways to both meet demand from borrowers and investors and satisfy regulators," said David Brittenham, chair of law firm Debevoise & Plimpton LLP's finance group.

Banks including JPMorgan Chase & Co, Bank of America Corp and Credit Suisse Group AG all have big leverage finance businesses.

The loans are also important for buyout shops such as KKR & Co LP and Apollo Global Management LLC, which often use debt to magnify their returns. These firms have warned in regulatory filings that the guidelines could erode returns in their private equity business because of limits in how much their companies can borrow.

One illustration of the guidelines' effect came last month, when some of KKR's closest banking relationships snubbed a request for a buyout loan over concern it is too risky to pass muster with US regulators.

Regulators, which are now reviewing banks' loan books to assess their credit quality and compliance with the guidelines, declined to comment on the workaround strategy.

A source familiar with the OCC's thinking said the agency is likely to crack down on strategies such as the use of holding company bonds that it thinks are meant to circumvent the guidelines and could lead to a bank getting fined. The feedback banks have received from regulators on the idea has been negative, other sources said.

The deliberations show the challenges regulators face in implementing financial reforms and curtailing the side effects of the Fed's cheap money policies six years after the financial crisis. By aiming for the most indebted companies, regulators are trying to reduce risk in the banking system as well as in the broader economy.

Perhaps the most infamous instance from that era was the $48 billion leveraged buyout of Texas power utility Energy Future Holdings in 2007, the biggest LBO in history. The deal's $40 billion debt was equal to 8.2 times adjusted EBITDA (earnings before interest, tax, debt and amortization). Energy Future filed for bankruptcy earlier this year.

For investors, junk bonds have been one way to find returns at a time when interest rates remain at record lows.

Banks are still trying to figure out how many deals that do not comply with the guidelines they will be allowed to do, the sources said. Regulators have told banks that these deals should be rare, but it is unclear what that means, they said.

For example, "rare" has been interpreted as anything from one or two deals a year to one or two percent of deals a bank does, the sources said. Banks are hoping that the regulatory review of their loan books will provide some clarity this summer.

The sources said allowance for a certain number of deals will also make putting together a lending syndicate for non-compliant financings challenging.

That's because every bank wants to be the lead arranger on a deal, which entitles it to most of the financing fees. The lead bank in a syndicate may be happy to use one of its allowances for a non-compliant deal, but will then have to persuade other banks to also use their allowance for a smaller cut of the fees, the sources said.

Workaround strategy

These challenges make the possibility of engineering a workaround even more attractive for banks. The idea contemplated takes advantage of the legal division of a company between an operating company that owns the physical assets and runs the day-to-day operations, and a holding company, which owns the equity in the operating company.

Companies typically borrow at the operating company level through loans. Since the loans can be secured against the company's assets, they are cheaper than other options.

They can also borrow through the holding company by issuing bonds. Payments on those securities are made from the cash that remains after the liabilities of the operating company are met, making them riskier than operating company loans.

Many holding company bonds are structured as payment-in-kind (PIK) notes that pay interest by adding to the outstanding principal rather than returning cash to the bond's holder - an even riskier proposition.

Such bonds are expensive for the issuer and the risk involved makes the investor universe limited, but the market has been growing as investors seek higher-yielding securities.

By having the holding company issue PIK notes, financiers hope they can appease regulators concerned about the drag of more debt on the cash flow of a company. It remains unclear whether regulators will be convinced, given their preliminary negative feedback.

Bankers point to a recent deal as an example of how that can work. In March, alternative asset manager Crescent Capital Group LP invested in PIK notes of Catalina Marketing Corp, owned by rival Berkshire Partners LLC, according to a source familiar with that deal.

Catalina's overall leverage reached 7.5 times EBITDA, according to Thomson Reuters Loan Pricing Corp. But the operating company leverage remained at 6.5 times EBITDA.

Credit rating agencies took the view that the move to issue PIK notes was positive for operating company creditors because they would not draw on Catalina's cash.

Berkshire Partners and Crescent Capital declined to comment on the motives for that deal. Sources close to the transaction said the bonds were aimed at giving more financial flexibility to the operating company rather than to circumvent the guidelines.

Copyright @ Thomson Reuters 2014