The prolonged period of very low interest rates and the ensuing search for yield strategies have warranted specific monitoring of credit quality by the European Central Bank (ECB) in general and of leveraged finance exposures in particular.

Borrower-friendly conditions have further translated into a weakening of deal structures (increased leverage levels, import of “covenant-lite” structures into European markets) and in many cases have led to greater relaxations in credit institutions’ policies.

Moreover, several areas for improvement in credit institutions’ monitoring practices have been identified, as well as significant discrepancies in individual institutions’ approaches to defining, measuring and monitoring leveraged transactions.

Based on that, ECB considers that closer supervisory scrutiny of leveraged transactions is justified. This closer scrutiny has led to the release of guidance from the ECB summarising key supervisory expectations concerning leveraged transactions, and the ongoing monitoring of both syndication risk and the fundamental credit quality of leveraged exposures.

Accordingly the internal implementation of supervisory expectations expressed in this guidance should be consistent with the size and risk profile of institutions’ leveraged transactions relative to their assets, earnings and capital. This ECB guidance came into force in November 2017.

Definition of leveraged transactions

According to the ECB, any transaction meeting at least one of the conditions below should qualify as a leveraged transaction:

• The borrower’s post-financing level of Leverage exceeds a Total Debt to EBITDA ratio of 4.0x *
• The borrower is owned by one or more financial sponsors

*/ whereas, Total Debt refers to total committed debt (comprising of drawn and undrawn parts of Committed facilities plus the drawn part of Uncommitted facilities) as well as any additional Permitted Indebtedness allowed as per legal documentation.

The leverage multiple should be calculated at the consolidated borrower level, unless group support cannot be assumed in case the borrowing entity is experiencing financial difficulties.

Therefore, where the Banks provide credits on the basis of a guarantee, the guarantor’s consolidated financials and assessment debt repayment (by that guarantor) prevails.

Notwithstanding the conditions described above, the ECB has specified a number of transactions that are considered as out of scope for leveraged transaction like following:

• Undrawn parts of Uncommitted Facilities;
• Off-balance sheet products (e.g. guarantees facilities, Trade finance lines etc.);
• Loans categorized for Specialized financing (REF, Commodity finance etc.);
• Loans to SME entities;
• loans where the own consolidated exposure of the credit institution is below €5 million;
• loans to investment-grade borrowers (i.e. with a rating equivalent to BBB-(S&P)/BBB- (Fitch)/Baa3 (Moody’s).

As part of their internal risk appetite framework, credit institutions should define their appetite and strategy for leveraged transactions, as defined above, in a way that encompasses the various business units involved in such operations. To this end, senior management is expected to define, review and endorse at least on an annual basis the limits allocated to leveraged transactions. Exemptions and increases in limits, if any, should be duly justified.

In particular, credit institutions should have defined a strategy for syndicating leveraged transactions. The guidance lists a number of internal standards that should be taken into consideration.

As an example, the ECB made it clear that high leverage levels, defined as the ratio of Total Debt to EBITDA ratio exceeding 6.0x at deal inception, should remain exceptional.

Further, an assessment of the structure of the transaction and related term sheets (covenant, leverage level, dividend distribution, capex features). Internal systems at credit institutions must flag any structures presenting weak covenant features, such as the absence of any covenant, the absence of financial covenants in the contractual agreements with a borrower or the presence of significant headroom in these financial covenants. Any breach of covenant should also be tracked.

Both the assessment of the nature of the facility and a behavioural analysis of the borrower’s appetite to drawn commitments, including in times of stress (as per Article 5 of Commission Delegated Regulation No 2015/61), should be part of a sound classification of the commitment between a credit line and a liquidity line for the purpose of calculating the Liquidity coverage ratio (LCR).

Follow-up activities

Eighteen months after publication an internal audit report shall be drawn up and submitted to the joint supervisory team, detailing how the expectations expressed in this guidance have been implemented by the credit institutions in their procedures. Further, this report should also include detailed analysis of credit portfolio with respect to: (a) market trends (b) leverage transactions development per sectors (c) internal limits (d) weak covenants structures connected with large exposures (e) failed syndications etc.

Besides this, a credit approval process should be set up for all transactions to align the leveraged transaction level with the institution’s risk appetite. For this purpose, an in-depth due diligence should be conducted for any new transaction, renewal, or refinancing of an existing leveraged transaction. The independent risk function in charge of performing the due diligence should consider the following elements:

• An in-depth assessment of the borrower (Cash-flow generation), so that it must be demonstrated that the borrower can repay ≥ 50% of Total Debt over a period of maximum 7 years
• Stress test on the business plan and projections provided by the borrower, whereas the Stress Case should reflect a realistic deterioration of financial performance, ideally based on historic performance during an economic downturn and reflect specific borrower, industry and geographic circumstances. In case the above ≥ 50% debt repayment target is not met, the responsible decision makers should provide arguments for justification
• An enterprise valuation (EV) the borrower – this is applicable for Acquisition financing, as EV is considered as primary justification for ability to service the Debt in the future, so that Banks are required to perform regular test on EV during the credit review (using either comparable EBITDA multiplies or discounted Cash Flow methods).
• An assessment of the structure of the transaction and related term sheets meaning to have in place exact rules and pre-conditions on determining the level of covenants structure (strong, medium and weak).
• and others applicable.

source: www.ecb.europa.eu, www2.deloitte.com