Speed Bumps Seem to Be Slowing Traffic in the Capital Markets

By Will Bloom and Dan Kaczmarek

Speed bumps are typically built to slow motor vehicle traffic in order to improve safety conditions. They are not meant to stop a driver from reaching the desired destination. A similar dynamic may be affecting the deal making environment in the form of increased bank regulatory scrutiny for high levered lending.

CAPITAL MARKETS UPDATE

U.S. debt capital markets improved slightly during April and May following a volatile first quarter marred by global economic growth concerns (i.e., China), volatile commodity prices (e.g., oil), weak labor market, and monetary policy uncertainty. Federal Reserve policymakers again decided to keep rates steady until the economic outlook clears.


Source: Thomson Reuters

Despite a sluggish start to the year, April and May began to show signs of increased levered lending as evidenced in the preceding chart (data available through April). Although levered loans remained obtainable for high-quality issuers, the trepidation to lend deep into the enterprise value impacted the debt capital markets and thus directly affected M&A activity. By some accounts, Q1 2016 completed M&A deal activity was at its lowest level since early 2009 following the Lehman Brothers collapse. (See announced M&A deal activity illustrated in the chart below). The fall-off in activity was likely driven by the above mentioned macro market uncertainty as well as a lack of quality sellers in the marketplace, more sluggish lending environment (further elaborated on below), and the prospective beginning of a valuation gap between buyers and sellers. Amongst the uncertainty, one thing that remains certain is the dearth of capital looking for a home. We do not see this changing much during the next few years. In fact, we expect to experience a spur in activity as the year progresses, despite the upcoming election and any impact it may have on the economy.  


Source: S&P Capital IQ

HIGHLY LEVERED TRANSACTIONS

Banks are currently carefully managing their participation lending into highly levered transactions, which we believe is a driver of the soft M&A deal environment. The specific dynamic stems from heightening regulatory scrutiny on traditional banks over leveraging borrower balance sheets.  Stricter review of “highly levered transactions,” or “HLTs,” is not new as guidance was originally jointly issued by the U.S. Office of the Comptroller of Currency, the Federal Reserve Board, and the Federal Deposit Insurance Corporation during 2013.  However, the feasibility of HLTs has increasingly become a part of conversations between banks and the federal agencies since mid-2015 as recent market conditions have generated added regulatory focus. In general, regulators require traditional banks to hold additional capital, or said another way, set aside more loan loss reserves, to account for riskier loans. As a result, banks must charge borrowers a higher rate for lending into these types of transactions to meet return hurdles while also managing their capital allocation and risk taking.

The initial levered lending guidance implied any loan issued above 4.0x the borrower’s earnings (EBITDA) for senior secured loans and 6.0x EBITDA in total indebtedness (both senior and subordinated debt) would be deemed an HLT.  Today, the guidance has compressed further for senior lenders, suggesting senior loans above 3.0x EBITDA would be considered HLTs. This being said, it is important to distinguish between loan types: collateralized loans and enterprise loans, also known as cash flow loans. Collateralized loans, as the term implies, are secured by assets that will more than cover the loan balance in liquidation, while enterprise value loans have little-to-no asset coverage. Banks continue to be aggressive and less concerned with regulatory guidance on leverage when strong collateral is provided by a borrower; however, we have observed a noticeable pull-back in lending beyond 3.0x into the enterprise value of the borrower thus far this year.  

The heightened enforcement of the HLT guidance has further opened the door for non-bank lending institutions to benefit. The diverging appetite for risk is causing an increase in spreads for loans issued by non-bank lenders (i.e., it is becoming more expensive for companies to borrow money). However, since the non-bank lenders are not restricted by federal HLT regulations, these institutions are typically willing to lend deeper into the capital structure of high quality issuers. This is one reason for the increased frequency of senior uni-tranche credit facilities.

SUMMARY

Market uncertainty and increasing regulatory pressure are likely two of the drivers behind the slowdown in credit market transactions and M&A activity during the first half of 2016. As a result, investors have become more selective, which is causing a divergence between value expectations for sellers, buyers, and/or investors. However, given the large amount of capital in the debt and equity markets, we continue to experience, relative to average, an attractive marketplace for sellers and issuers and foresee stronger activity during the second half of the year. We have experienced, and expect to continue to see, banks managing risk utilizing their low cost capital to formidably compete for business where appropriate. Like the analogy at the beginning of the article suggests, a speed bump will not stop a vehicle from reaching its destination but it will cause the driver slow down before proceeding. Having a trusted co-pilot to help navigate these obstructions is vital and Chartwell remains able and willing to help!