New federal guidelines that went into effect last year, known as Lending Leverage Controls, have made things confusing for underwriters, issuers, and investors. Underwriters are not sure how regulators will look at new leveraged loans that are being underwritten, and issuers and investors are unsure of what the impact on pricing and availability of capital will be for leveraged transactions.
Could it be that underwriters become more conservative and the generous lending and high valuations will come to an end? Will this provide a competitive advantage for non-regulated and non-bank lenders? Will this cause the debt capital markets to slow down dramatically as underwriters get a better understanding on how to apply the regulations? And, will this make it tougher for restaurant companies to secure the financing they need to manage and grow their business?
Implications of New Lending Leverage Controls
The market is still sorting out the implications of these guidelines, but they could have a significant effect on our fragile economy as access to credit tightens. Moreover, if the guidelines result in a decline in debt availability, restaurant company growth may slow and private equity funds may have to either lower valuations that have been reaching record levels and/or increase the amount of equity in each deal.
U.S. market regulators, including the Federal Reserve Board, the Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (OCC), are increasingly worried that prudent underwriting practices have eroded since the end of the global economic recession. In response, the regulators want to restrict bank loans with higher leverage levels and uncertain repayment prospects. Their goal is to avoid a repeat of the market meltdown brought on by years of reckless mortgage underwriting.
“As regulators, we certainly hope to change bad practices and remove the extraordinary froth that is experienced at the peak of a credit cycle,” Martin Pfinsgraff, a senior regulator at the OCC, recently told The Wall Street Journal. “The impact on private equity, a significant driver of what we see as risky practices, is an intended consequence of our actions.”
The new federal guidelines, which generally apply to leveraged loans of $20 million or more, went into effect last May. Under the guidelines, updated for the first time since 2001, leverage levels above six times debt-to-EBITDA after asset sales are now classified as “criticized loans.” In 2013, the percentage of U.S. leveraged buyouts with a debt-to-EBITDA ratio above six times was at 27%, the highest level since 2007, when it reached 52%, according to S&P Capital IQ LCD.
Banks that participate in deals that regulators consider too risky could face fines or other enforcement actions. The real concern for private equity - and for company owners looking to sell their businesses to private equity - is that these new guidelines could curtail the size and number of deals that get done.
Case in Point
Imagine, for example, a midmarket restaurant company in Cleveland that is poised for growth and wants a PE partner to take the business to the next level. The restaurant company and PE firm agree on a sale price based on a multiple of EBITDA and then bring in the bank to finance a large part of the transaction. In the past, most banks would be happy to make that loan and charge the associated fees. Now, however, banks might hesitate to proceed with a transaction that requires leverage levels above the guidelines for fear of angering regulators.
Clearly, the federal guidelines have the potential to hinder growth in the middle market. And those leveraged buyouts that do get done will likely come at reduced valuations. Until now, debt capital was freely available and relatively cheap, so PE firms could pay more for deals. If a PE firm put $10 million into a deal and took $40 million in debt, it could pay a total of $50 million for a company. But when a PE firm can only get $20 million in debt, it would either need to put up more equity or reduce the valuation, which will certainly have an effect on prospective returns and possibly deal terms.
In some cases deals will be squashed altogether. The Wall Street Journal recently reported that Bank of America, Citigroup, and JPMorgan Chase are among lenders that have in recent months decided against financing some corporate takeovers partly out of concern that the deals will run afoul of the new federal guidelines. Citigroup decided, in part because of the new guidelines, not to finance KKR’s $1.6 billion leveraged buyout of commercial landscaper Brickman Group, according to published reports. No matter the size of the deal, this issue will continue to come up.
The Flip Side: Tighter Lending Standards Open Opportunities for Non-Traditional Lenders
The new regulations are not bad news for everyone. As regulated banks grapple with tighter lending standards, their non-regulated competitors can rush in to fill the vacuum. These lenders - which include broker-dealers like Jefferies Group, the credit arms of megabuyout firms like KKR and Blackstone Group, and finance companies, hedge funds and insurance companies - are not regulated as banks are and do not face the same strict requirements.
Nonbank lenders accounted for 83% of total middle-market volume last year, up from 77% in 2012 and 70.6% in 2011, according to S&P Capital IQ LCD. And, thanks to the new federal guidelines, their share of the pie seems likely to grow, as regulated banks find it harder to compete and private equity firms expand the number of lenders they approach.
Underwriters are still examining the new guidelines and determining which deals will pass the sniff test. For instance, will the feds deem a loan “criticized” if it fails one, two, or all of the updated guidelines? And what number of criticized loans can a bank have on its balance sheet before running afoul of regulators? Amid this uncertainty, banks are starting to play it safe and avoiding deals that could land them in hot water.
For middle-market companies that are thinking of partnering with a private equity firm, the new federal guidelines mean that, if they want to go to market and get the very best price for their business, they better get moving in the next six months. Until the new guidelines are fully enforced, capital will likely remain available and debt will remain cheap. But when the enforcement starts, credit will tighten and valuations could plummet.
What Does CohnReznick Think?
If you are considering going to market to take advantage of the recent valuations, we suggest you get started soon. It is only a matter of time before valuations come down and the new lending regulations become a headwind for the hospitality industry. If regulated banks can no longer lend to companies that are at or above the six times debt-to-EBITDA threshold, a significant source of debt capital in private equity transactions could quickly dry up. The market is driven by the availability of inexpensive debt capital - but if a major source of debt capital is suddenly removed from the market, the ability of private equity firms to close deals, as well as the ability of sellers to get the highest price for their companies, could be negatively impacted. At the same time, nonbank lenders could gain a competitive advantage, as they are not regulated and the new guidelines do not apply to them. Once underwriters fully understand how to apply these rules, access to cheap financing may come to a screeching halt, leaving PE funds and entrepreneurs to find alternative ways to get deals done with more expensive debt, lower valuations, or new deal terms.
For more information, please contact Jeremy Swan, Principal, Private Equity and Venture Capital Practice, at (646) 625-5716, or Gary Levy, Partner and Hospitality Industry Practice Leader, at (646) 254-7403.
To learn more about CohnReznick’s Hospitality Industry Practice, visit our webpage.
This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.