Leveraged lending partnerships raise market concerns

Author: Zoe Thomas | Published: 7 Jul 2014
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The US Federal Reserve’s leveraged lending guidelines have raised concern that liquidity could be stretched making it difficult for mid-market firms to find financing. But partnerships between banks and business development companies (BDC) are offering a way to fill that gap.

BDCs are not entirely new. Banks have arranged and partnered with other banks and shadow banks to issues multi-tranche loans before.

However, the increasing amount of leverage in the market and the idea that banks are skirting the guidelines through these partnerships has raised the eyebrows of market participants and regulators. Until regulators form a clear opinion on the issue or market conditions change, the trend seems set to continue.

"I expect that as more regulators give feedback to banks about their portfolios and the structures being used, banks will have a better sense of what they can do," said Geoffrey Peck a partner at Morrison & Foerster. "Depending on that review, there may be banks looking to fashion creative structures around that review."

KEY TAKEAWAYS

  • Banks and business development companies are partnering up to offer leveraged loans to mid-market companies;
  • It’s unclear whether regulators will step in to prevent the progress of these deals;
  • Business development companies and mid-market firms are benefiting due to the higher interest rates placed on the unsubordinated section of the loans.

Regulatory reaction
That concern has led to mixed reaction from regulators, with figures from the Office of the Comptroller of Currency (OCC) informally saying that it was concerned about these partnerships. Banks have noted that the OCC is the regulator who most strictly enforces the guidelines.


" It is highly likely BDCs will become a larger part of the financing spectrum "




However, no official ruling has been made about them.

Some regulators are also expressing concern about the amount of leverage in the financial system. With banks being the main target of regulation and little consensus on how to bring the overall amount of leverage down, few expect changes in the near-term.

BDC- bank partnerships will therefore likely continue to add leverage to the system without exceeding the leverage regulators allow banks to hold.

Most of the loans being issued rely on a unitranche structure where the banks hold the senior loan and the BDC issues the subordinated section. Apart from allowing banks to hold less leverage, this structure has benefits for the BDCs and borrowers.

A cost-balance
For borrowers, particularly in the mid-market, access to capital can be limited as banks become more cautious about what they put on their books, or more expensive if it comes from shadow lenders looking for high returns. These partnerships create a cost balance.

Likewise for BDCs, which have higher capital costs than banks, the subordinated loans come with higher interest rates to help increase investor yield.

BDCs are a product of the 1980s economic downturn. Created as an amendment to the 1940 Investment Act, they are closed-end funds, similar to hedge or private equity funds, but without the requirement that investors be accredited. Their goal was to help drive funding to small businesses that were not receiving it from banks.

"The resurgence of BDCs is likely due to the cyclical nature of the economy and we are seeing similar stages in that cycle to the ones in which BDC were originally legislated," said Rossie Turman, a pattern at Skadden.

Arrangers
Banks too are not acting far from their traditional role in these deals. Most of the banks generate revenue from activities other than traditional lending, including loan arranging.

"I think it is highly likely BDCs will become a larger part of the financing spectrum," said Turman. "BDCs are another provider of capital in leveraged lending that are able to fill the gap created as banks are forced to reduce the amount of liquidity they can place in the market."

With the market expected to stay in this condition and regulators yet to make their position clear, this trend seems likely to flourish. A harsh reaction from regulators could even see a drop in liquidity for the mid-market.

"Regulators are reviewing banks’ leverage guidelines and portfolios to see how well the banks’ portfolios match the guidelines," said Peck.

He added: "If BDCs and other non-banks feel they need bank partnerships to do their business and the regulators come down on banks, this could affect the ability of mid-market companies to leverage their businesses in an appropriate way."


Further reading

Stress test changes strain bank capital plans

US to toughen up on leveraged lending rules

Lending trends that will outlive cov-lite

 


 

 

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