The Debt Connection – February 2017

In the latest Debt Advisory newsletter from Clearwater International, we look at proposed ECB guidelines on leveraged transactions, which could restrict banks and present opportunities to alternative/specialist providers of debt.

Towards the end of last year, the European Central Bank (ECB) started a consultation on leveraged loan transactions, including a proposal for a standardised definition of EBITDA profitability across European banks, as well as a push for improved internal monitoring standards of existing loans and better due diligence assessments. Included within these proposals were references that leverage ratios of 6x or greater should be by exception, and require immediate referral to the highest level of credit for decisions.

When you think back to the global financial crisis, the suggestions appear sensible, but the definition of what constitutes leveraged finance is not clear enough. According to the ECB, a leveraged transaction is “all types of loan or credit exposure where … leverage exceeds a total debt to EBITDA ratio of four times”. This is quite broad and unclear on the face of it.

As the definition is so broad, this could mean banks have to reclassify what they consider to be standard corporate loans as leveraged transactions. This would result in additional monitoring measures and reporting being required, but also the potential for new capital to be raised if the loans are now considered higher risk. This would provide a further burden on the banks and potentially limit their appetite to lend.

It has been noted that the ECB’s recommendations are similar to those introduced in the US three years ago. While these are not the final rules, it does outline that European regulators want to see a reduction in risk levels at banks and more alternative sources of capital enter the European mid-market lending space.

The impact of this on businesses is the potential future reduction in the amount of liquidity in the market, to support entrepreneurial businesses looking to grow. Those businesses which are asset heavy and perhaps have asset finance, finance leases, higher purchase lines or off balance sheet funding, could be impacted most by these changes.

The debt funds and direct lenders are likely to be the winners if these proposals are implemented due to their lower regulatory requirements when compared with traditional banks. This would provide opportunities for their share of the market to grow within Europe and perhaps shift further towards that seen in the US, where the majority of mid-market lending is provided by non-bank lenders.

Debt fund managers are often quick to dispel any notion that they are in competition with banks, but it’s clear the private debt market has benefitted enormously from regulations placed on banks following the global financial crisis. The latest proposals from the ECB certainly have the potential to aid that trend.

For mid-market businesses, it is important to keep appraised of the changes in the lending market and take advantage of the opportunities and sources of funding that are available to them. There are more options available today than ever.