Credit funds eye opportunity in ECB limits on bank leverage

"From our perspective, the ECB guidelines are fabulous – to be blunt," says Andrew Konopelski, partner and head of EQT Credit Strategies. "I think they will accelerate the shift from a traditional bank-led market to an institution-led market, which is quite positive for us."

EQT launched its credit outfit in 2008, and many other European and US private equity outfits have followed suit since. BC Partners, owner of unquote" parent Mergermarket Group, is among the most recent joiners in the private debt market, announcing the launch of BC Partners Credit in February 2017.

BC joins private equity firms such as Ardian, CVC Capital Partners, HIG Capital and Permira in a European private debt market that has grown explosively over a very short period of time, while Bridgepoint is rumoured to be considering its own foray into credit. While investment strategies vary from firm to firm, most will have a fund able to provide or acquire senior debt and buyout leverage.

"There are a lot of credit funds and other kinds of debt providers in the market already, and the numbers are increasing," says Bernd Egbers, partner in the Munich offices of law firm Ashurst. "We see a lot of different levels of debt at the moment because there's already a lot of money in the market, and therefore we also see an increase in leverage – particularly in deals for really good assets."

Banks are not always the best judges of credit – that's been proven in the past – and they are not necessarily the most stable capital base at times, in terms of asset liability matching" – Andrew Konopelski, EQT

His view is supported by Paul Johnson, a partner at EQT Credit: "We think there will be some tailwinds for funds in the senior debt space and at the other end of the risk/return spectrum. EQT Credit started out with credit opportunities," he says, explaining that if loans exceed the ECB limit while still running – and should that in turn create an opportunity – the fund is well suited to benefit from it.

Historically, senior debt in European buyouts has been provided almost exclusively by institutional lenders, mainly banks. Now, the possibility of suggested limits being imposed on bank leverage could open up the European debt market to more private sources of financing.

In late November 2016, ECB published draft guidelines on leveraged deals, setting out how the regulator expects banks to uphold the quality of their leveraged loans and monitor balance sheet risk. Not yet published, ECB's draft was open to comment from the industry and public until 27 January and featured a public hearing on 20 January.

ECB's initial draft was broadly similar to leverage guidance put out by US federal bank regulators in March 2013, a key feature of which was to prescribe a recommended upper limit on leverage levels in buyouts. Applying to credit institutions considered "significant" – likely any bank with more than €30bn in assets – ECB's draft suggests that total gross debt exceeding 6x unadjusted EBITDA in deals that create underwriting or syndication risks for a bank should only be provided in exceptional circumstances.

Deals featuring leverage in excess of this level should be thoroughly justified and referred to the most senior credit committees of the banks involved, the ECB draft proposes. Additionally, loans that fail to be syndicated within 90 days of closing would be identified and monitored through a dedicated framework.

"It's a fairly blunt instrument ECB is using," says EQT's Konopelski. "It's quite clear that regulators do not feel they can trust banks to regulate themselves and do sensible things. Banks are not always the best judges of credit – that's been proven in the past – and they are not necessarily the most stable capital base at times, in terms of asset liability matching."

Going private
At 6x unadjusted EBITDA, most leveraged transactions in the European buyout market will likely not be affected by the ECB guidelines. Average debt levels currently sit a good deal below the level floated by the ECB in most regions.

"If you look at the German market as an example, a debt multiple of 6x is quite a high level of leverage for a deal," says Egbers. "The ECB is looking to limit leverage, but given the chosen limit, you can question whether this is really a limit on the leverage market – or more of a guideline that rarely comes into force because levels are different in practice."

However, parts of the European lending market believe the draft could counteract its intended purpose and prevent good credits from raising debt. Software and IT services companies are expected to be among the assets to fall afoul of the guidelines, due to their highly cash-generative and fast-growing nature, which typically allows for a higher leverage off the bat. "Perversely, it could hinder the best credits and more stable businesses that would have allowed for higher leverage, and you may end up with more aggressively levered cyclical businesses because they are the ones that can be done," says EQT Credit partner Paul Johnson. "If a company is reinvesting in itself, a really good credit risk could fall afoul of the ECB guidelines."

Johnson says some of the bankers he has spoken to are confident the best credits will be able to get exceptions, but he says there is widespread agreement that it would take some marginal capacity out of the buyer universe: "There will be banks that won't want to do whatever they need to do to classify a deal as exceptional."

The ECB guidelines will lead to increased opportunities for the private debt market, but I think there is sufficient capital – and certainly desire – for private debt markets to address the issue" – Andrew Konopelski, EQT

Bank reluctance to push out highly levered debt could ultimately create friction between the lenders and sponsors, with GPs bearing the brunt of the costs. Private equity firms will have to find creative solutions through the private market if banks become unwilling to jump through ECB-mandated hoops.

Konopelski says main sources of friction will be in revolving credit facilities and day-to-day banking, as well as amending existing facilities, as the private market lacks capacity in these areas. "It will be difficult for sponsors in highly levered transactions to get the revolvers in place that they need to manage the working capital flows of their businesses. They're either going to have to over-lever those companies, recapitalise to carry more cash, or find another way to tap it," he says.

He also predicts difficulty in amending existing facilities under the ECB draft. "In the US, if a loan has increased past 6x or 7x leverage, perhaps because of underperformance or cyclical headwinds, the banks are put on notice that they can't amend the documents, or help raise additional financing – they really can't be involved in a lot at all," Konopelski says. "Even if it's a credit-enhancing move, their hands are really tied. It can be very frustrating for some sponsors that they can't do sensible things for their business because of banking regulations."

For now, ECB is yet to publish or implement any formal guidelines and the development of leveraged loans regulations is still underway.

At Ashurst, Egbers believes the ECB guidance will be just that: guidance. "From my perspective, this seems to be more of a message to the industry saying 'Be careful and get your numbers right, and be able to justify why you would go above the level' – rather than being strict regulations," he says.

EQT Credit's partner does not underplay the impact: "The ECB guidelines will lead to increased opportunities for the private debt market, but I think there is sufficient capital – and certainly desire – for private debt markets to address the issue," says Konopelski.

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