ECB leverage guidelines: casting too wide a net?

In late November 2016, the European Central Bank (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. The final guidance was published in May this year, and is expected to come into force in November.

The guidelines cover "significant supervised entities" as determined by the ECB (around 124 institutions at the moment) and will only apply to sponsor-backed loans with total committed gross debt facilities of more than 4x. Transactions with total committed gross debt facilities in excess of 6x will be considered "over-leveraged".

On the face of it, the scope of PE-backed transactions falling under the latter bracket should be fairly limited. As debt advisory firm Marlborough Partners noted in its Q2 Quarterly Snapshot report, deals leveraged at more than 6x have accounted for 11% of all transactions on average over the last three years.

But the adviser also warned that a strict interpretation of the guidelines as they currently stand could actually catch a much greater number of deals, where leverage would traditionally be thought of as moderate. "The definition of total committed debt facilities outlined above includes undrawn debt, PIK and any additional debt that loan agreements may permit such as incrementals/accordions," the report reads. "Given that it is not unusual that revolvers account for 1x EBITDA and freebies and baskets can account for another 1x, then this would translate to 4x term debt."

My feeling is that we will ultimately move towards a solution more in line with the Fed approach in the US, whereby the guidelines would include PIK and undrawns but leave out baskets, and common sense will prevail and shareholder loans will not be included" - David Parker, Marlborough Partners

According to Marlborough, applying the guidelines on that basis could mean that up to three quarters of all deals done over the past three years would be considered over-leveraged. And although this remains guidance as opposed to strict rules, banks would most likely not ignore the guidelines other than in exceptional occasions.

Comparing the potential impact with the situation seen in the US following the implementation of the Fed guidelines, Marlborough noted that, according to a recent Staff Report by the Fed in May 2017, banks subject to the guidance cut their leveraged lending activity significantly, bringing it down to levels lower than seen in the pre-guidance period. Non-regulated banks did not adjust their leveraged lending and non-bank lenders increased their leveraged lending.

As unquote" explored back in March, the guidelines should result in a further boost for non-bank lending in Europe, as such lenders wouldn't have to comply with the ECB guidelines. Marlborough also highlighted that, unlike in the US where nearly all lenders were affected by similar guidelines from the Fed, a number of the top bank lenders in European deals would also fall outside the guidelines. These include Goldman Sachs, JP Morgan, Credit Suisse and Bank of America Merrill Lynch; while this could result in some "small market share shifts", Marlborough managing partner David Parker stressed that the US banks would in all likelihood still comply with the Fed guidelines, which would negate their advantage somewhat compared to ECB-regulated players.

The ECB is still consulting ahead of the actual implementation by year-end, and Parker believes the final result could ultimately be more amenable to leveraged PE transactions. "My feeling is that we will ultimately move towards a solution more in line with the Fed approach in the US, whereby the guidelines would include PIK but leave out baskets, and common sense will prevail and shareholder loans will not be included," Parker told unquote".

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