Leveraged Lending: Evolution, Growth and Heightened Risk

Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION

Introduction

Leveraged lending provides credit to

commercial businesses with higher

levels of debt and also helps companies

obtain funding for transactions

involving leveraged buyouts (LBOs),

mergers and acquisitions (M&A),

business recapitalizations, and

business expansions. Many commercial

businesses successfully utilize and

repay these loans; however, high

debt levels coupled with lower levels

of liquidity may reduce businesses’

flexibility to respond to changes in

economic conditions. The recent

period of economic expansion

combined with low interest rates

provided companies with the

opportunity to increase their debt

levels over the past decade. As a result,

more businesses sought, and received,

leveraged loans.

The FDIC recognizes the important

role that leveraged lending has

in the global market economy, as

well as the important role insured

depository institutions (IDIs) serve

in providing credit to companies

through originating and participating

in leveraged loans. Underwriting and

bank risk-management practices are

expected to be commensurate with the

potential heightened risk associated

with this type of lending, and IDIs

and the leveraged-lending market as a

whole benefit from the origination of

soundly underwritten loans.

The FDIC and other Federal

Regulatory Banking Agencies (FBAs)

closely monitor industry leverage

trends, and banks’ underlying risk-

management practices associated with

this type of lending.

See, e.g., the Interagency Safety and Soundness Standards in Appendix A of Part 364 of the FDIC’s Rules and

Regulations, and the risk management practices outlined in the Interagency Guidance on Leveraged Lending.

https://www.fdic.gov/news/news/financial/2013/fil13013.pdf.

The interagency Shared National

Credit (SNC) Program is conducted

twice each year and is a primary

mechanism for the FBAs to monitor

leveraged lending in IDIs related to

portfolio growth, underwriting trends,

and risk management practices.

A SNC is defined as a loan greater

than $100 million made by three or

more institutions, which includes

various types of loans, in addition to

leveraged loans. The FBAs publish

annual results of the combined semi-

annual SNC review, which includes

details on leveraged lending trends

and associated risks. The FBAs also

conduct targeted examinations of

leveraged lending activity in addition

to ongoing supervision to assess risk

in this area.

Both bank and non-bank entities are

involved in leveraged debt financing.

Banks held approximately 63 percent

of leveraged loan commitments in

the SNC portfolio as of December 31,

2018, compared to 37 percent held

by non-banks. This article focuses

primarily on exposure in the banking

sector, and the content is based

on observations from SNC results

and examination findings at FDIC-

supervised IDIs.

Leveraged Lending Defined

Leveraged lending has no universal

definition and is not defined in

exact terms by regulatory agencies.

Supervisory guidance establishes a

range of potential criteria,

and IDIs

generally consider overall borrower

risk, loan pricing, and measures

of leverage (in terms of debt to

income) when defining leveraged

credits within bank policies. Credit

Leveraged Lending: Evolution, Growth and

Heightened Risk

Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION

rating agencies typically define

leveraged lending as loans rated

below investment grade level, which

is categorized as Moody’s Ba3 and

Standard & Poor’s BB-, or lower, and

for loans to non-rated companies that

have higher interest rates than typical

loan interest rates.

The SNC program tracks leveraged

lending based on information reported

by IDIs, and therefore accurate

reporting by institutions is critical.

As disclosed in the January 2019

SNC public statement, bank-reported

leveraged credits in 2018 totaled

approximately $2.1 trillion, of which

$700 billion was investment grade.

This level is consistent with the

leveraged loan market size noted by

the rating agencies at $1.2 to 1.3

trillion, which excludes investment

grade

Leveraged Lending Risk

Results from SNC reviews have

highlighted building risk in terms of

dollar volume and loan structures.

In 2014, the FBAs issued a “Leverage

Lending Supplement” that highlighted

underwriting and risk management

https://www.fdic.gov/news/news/press/2014/pr14096.html.

https://www.fdic.gov/news/news/press/2019/pr19004a.pdf.

The Interagency Safety and Soundness Standards in Appendix A of Part 364 of the FDIC’s Rules and

Regulations, as required by Section 39 of the Federal Deposit Insurance Act, addresses the importance of

prudent credit underwriting, loan documentation requirements, and asset quality controls and monitoring

practices. In addition, IDIs engaged in leveraged lending should be aware of the risk management practices

outlined in the Interagency Guidance on Leveraged Lending.

Special mention commitments have potential weaknesses that deserve management’s close attention. If left

uncorrected, these potential weaknesses could result in further deterioration of the repayment prospects, or in

the institution’s credit position in the future. Special mention commitments are not adversely rated and do not

expose institutions to sufficient risk to warrant adverse rating.

Substandard commitments are inadequately protected by the current sound worth and paying capacity of

the obligor or of the collateral pledged, if any. Substandard commitments have well-defined weaknesses that

jeopardize the liquidation of the debt and present the distinct possibility that the institution will sustain some

loss if deficiencies are not corrected.

Doubtful commitments have all the weaknesses of commitments classified substandard and when the

weaknesses make collection or liquidation in full, on the basis of available current information, highly

questionable or improbable.

weaknesses in this sector.

Since

then, risk management practices

have improved significantly at most

IDIs involved in structuring and

underwriting leveraged transactions.

However, credit structures themselves

have continued to weaken reflecting

heightened demand for leveraged

credit and non-bank preferences on

terms. Findings from the 2018 SNC

review,

state that “many leveraged

loan transactions possess weakened

transaction structures and increased

reliance upon revenue growth or

anticipated cost savings and synergies

to support borrower repayment

capacity.” IDIs purchasing leveraged

loans should be fully aware of the risk

and possess the skills to measure,

monitor, and control it.

The increased risk in leveraged

lending is illustrated in the volume

of leveraged loans that are listed

for Special Mention

or subject to

adverse classification by the FBAs. Of

the $295 billion in Special Mention

and adversely classified loans within

the total $4.4 trillion SNC portfolio,

leveraged loans comprise 73 percent

of special mention commitments, 87

percent of substandard

commitments,

45 percent of doubtful

commitments,

Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION

Leveraged Lending

continued from pg. 11

and 76 percent of non-accrual

loans.

A material downturn in the economy

could result in a significant increase in

classified exposures and higher losses.

Non-bank investors in leveraged

loans are primarily collateralized

loan obligations (CLOs), pension

funds, exchange-traded funds (ETFs),

and managed funds. These entities

have increased their participation

in the leveraged-lending market

via purchases of loans or direct

underwriting and syndication of

exposure and more leveraged lending

risk is being transferred to these

entities. This trend and heightened

competition have caused a shift from

traditional IDI loan structures. In

order to satisfy investment demands,

banks began to structure leveraged

lending products that more closely

resemble a bond than a corporate

loan. For example, leveraged term-

loans carry few if any financial-

maintenance covenants. Additionally,

these loans often require only

minimal debt amortization, which

underscores that the likely repayment

source is debt refinance.

Large IDIs that syndicate and arrange

a majority of the leveraged loans

hold few if any of these term-loan

facilities on their books, but often

provide funding for the revolving-

credit facilities. A revolving credit

facility provides the borrower with the

flexibility to draw down, repay, and

withdraw again. During an allotted

period of time, the facility allows the

borrower to repay the loan or take

it out again. While IDIs traditionally

arrange and distribute leveraged loans,

and serve as administrative agents

for those loans, non-bank direct

Nonaccrual loans are defined for regulatory reporting purposes as loans and lease-financing receivables that

are required to be reported on a nonaccrual basis because (a) they are maintained on a cash basis owing to a

deterioration in the financial position of the borrower, (b) payment in full of interest or principal is not expected,

or (c) principal or interest has been in default for 90 days or longer, unless the obligation is both well secured

and in the process of collection.

https://www.fdic.gov/regulations/laws/rules/2000-8600.html.

lenders have become more involved in

originating and syndicating leveraged

loans in recent years.

Effective Risk Management

The Interagency Guidelines

Establishing Standards for Safety and

Soundness

(Guidelines) outline the

standards the FDIC uses to identify

and address potential safety and

soundness concerns and ensure action

is taken to address those concerns

before they pose a risk to the Deposit

Insurance Fund. The Guidelines set

forth a framework for appropriate risk

management that can be applied to

leveraged lending based on the size of

the institution and the nature, scope

and risk of its activities.

Among other expectations, the

Guidelines state that an institution

should have:

 internal controls and information

systems that provide for effective

risk assessment; timely and

accurate financial, operational, and

regulatory reports; and adequate

procedures to safeguard and manage

assets;

 loan documentation practices that

enable the institution to make

an informed lending decision

and to assess risk, as necessary,

on an ongoing basis; identify the

purpose of a loan and the source

of repayment, and assess the

ability of the borrower to repay

the indebtedness in a timely

manner; demonstrate appropriate

administration and monitoring of a

loan; and take account of the size

and complexity of a loan;

Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION

 prudent credit-underwriting

practices that are commensurate

with the types of loans the

institution will make and that

consider the terms and conditions

under which they will be made;

consider the nature of the markets

in which loans will be made; provide

for consideration, prior to credit

commitment, of the borrower’s

overall financial condition

and resources, the financial

responsibility of any guarantor, the

nature and value of any underlying

collateral, and the borrower’s

character and willingness to repay

as agreed; establish a system of

independent, ongoing credit review

and appropriate communication to

management and to the board of

directors; take adequate account

of concentration of credit risk; and

are appropriate to the size of the

institution and the nature and scope

of its activities; and

 a system to identify problem assets

and prevent deterioration in those

assets; conduct periodic asset-

quality reviews to identify problem

assets; and provide periodic asset

reports with adequate information

for management and the board

of directors to assess the level of

asset risk.

Risk management programs for IDIs

that originate or arrange leveraged

loans or participate in a large volume

of leveraged loans should be more fully

developed and comprehensive versus

IDIs whose leveraged lending activities

are limited in volume and size relative

to its overall capital and reserves.

Underwriting Trends

In accordance with the Guidelines,

IDIs are expected to develop policies

and procedures that identify and

measure risk, monitor leveraged

credit, and implement sound

underwriting and risk management

practices. As mentioned, leveraged

loan volume has increased and loan

structures have weakened. This trend

has, in part, been driven by increased

competition for such products, as well

as by the increasing fees generated

by originating these credits.

Examination data shows that some

IDIs have purchased participations

in leveraged loans without fully

assessing the risk or developing

appropriate policies and procedures.

In recent years, lenders have allowed

covenant protections to erode.

This trend results in fewer lender

protections. This point is illustrated

by Moody’s in its Loan Covenant

Quality Indicator (LCQI) graph of

newly originated leveraged loans as

noted in Moody’s Investors Service

press release dated April 24, 2019. and

is supported by published findings of

annual SNC reviews.

Since 2012, Moody’s has tracked

the quality of covenants in newly

originated loans for the quality

of financial covenants, structural

priority, restrictive payments, debt

issuance, investment and asset

sales, and general lender rights. The

graph illustrates the weaker trend of

covenant protection since 2016, which

highlights the risk faced by IDIs

lending to leveraged borrowers.

Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION

Leveraged Lending

continued from pg. 13

As mentioned previously, the 2018

SNC review found that leveraged loan

transactions possessed weakened

transaction structures that may limit

borrower repayment capacity, and

by extension, cause losses at IDIs.

These weaknesses are discussed

more fully below.

Capital Structure and Lender

Priority

Leveraged borrowers use a

variety of debt and equity to fund

acquisitions, asset purchases,

dividends, and refinancing

transactions. IDIs typically provide

all of the first lien senior secured

revolving lines of credit as well as

some of the first lien senior secured

term loans in leveraged transactions.

As mentioned, leveraged first

lien term loans may have limited

amortization requirements. Junior

debt facilities typically require no

amortization.

The capital structure may also

include junior debt such as senior

secured bonds, subordinated

mezzanine debt, or other hybrid

equity facilities that only require

interest payments or payment-

in-kind (PIK). Junior debt has

historically provided additional

protection to senior secured lenders;

however, the protection has declined

in recent years, as more leveraged-

loan transactions contain only first

lien senior secured debt in the

capital structure.

This trend implies greater reliance

on lender protections, which include

the value of the entity as a going

concern, the value and quality of

collateral, support from sponsors and

guarantors, and covenant protections.

Most leveraged loans are secured

by all business assets and common

stock of the company (Enterprise

Value), which results in valuing

the company based on its ability

to generate recurring cash flow.

Accordingly, the value of a company

can rapidly fluctuate. Examinations

have identified instances in which

IDIs failed to adequately monitor

enterprise value, or where enterprise

valuation methodologies were

inadequate. Failure to monitor this

lender protection could result in

insufficient reserves in the event of

borrower default.

Source: Moody’s Investors Service

Weaker Stronger

4.50

5.00

4.00

3.50

2.50

3.00

2.00

4.40

3.85

3.50

Q2-12

Q3-12

Q4-12

Q1-13

Q2-13

Q3-13

Q4-13

Q1-14

Q2-14

Q3-14

Q4-14

Q1-15

Q2-15

Q3-15

Q4-15

Q1-16

Q2-16

Q3-16

Q4-16

Q1-17

Q2-17

Q3-17

Q4-17

Q1-18

Q2-18

Q3-18

Q4-18

Q1-19

LCQ1 Scores 5 Year Average Weakest-Level Protection Threshold

Weak-Level Protection Threshold

Loan covenant quality scores, 2012-Q1 2019

3.30

3.18 3.18

3.60

3.56

3.57

3.54 3.52

3.67

3.78

3.77

3.61

3.65

3.78 3.79

3.36

3.55

3.87

4.06

4.04

4.08

4.10

4.00

4.05

4.08

4.13

4.03

3.92

3.30

3.18 3.18

3.60

3.56

3.57

3.54 3.52

3.67

3.78 3.77

3.61

3.65

3.78 3.79

3.36

3.55

3.87

4.06

4.04

4.08

4.10

4.00

4.05

4.08

4.13

4.03

3.92

Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION

Repayment Capacity

Effective analysis of a leveraged

borrower’s debt repayment capacity

can be challenging due to the complex

capital structures and rapid growth

strategies that are typical in leveraged

lending. IDIs develop models and

analyze repayment capacity using

cash flow assumptions developed by

the borrower or sponsor. Examiners

carefully scrutinize assumptions

promoting overly aggressive EBITDA

add-backs that do not reflect a ‘most

likely’ scenario in IDI repayment

models, and have identified instances

in which repayment modeling is not

well supported or overly aggressive.

Credit Agreement Protections

The loosening of terms within credit

agreements in recent years presents

a heightened level of risk for IDIs. For

example, many credit agreements

allow borrowers the right to obtain

additional debt without the current

lender’s approval, an ability known as

incremental facilities. The additional

incremental debt can result in

elevated leverage and dilute collateral

protection.

Financial-maintenance covenants

are also becoming rare in leveraged-

loan structures. Financial-

maintenance covenants play a vital

role as an early warning sign of

deterioration in a leveraged borrower.

For many newly originated leveraged-

loan transactions, protection consists

of “springing” covenants that limit

the use of revolving credit facilities

only after the revolver is drawn to a

specified level.

Leveraged-loan credit agreements

are also structured to allow a

borrower the ability to sell, transfer,

and purchase assets in the normal

course of typical operations, which

can expose lenders and investors to

reduced cash and collateral protection

and can affect repayment and

refinancing risk. Recent examples

include companies that have used

these “carve-outs” from the collateral

pool to move business lines and

intellectual properties to affiliates of

the borrower, which resulted in lower

potential borrower enterprise value.

Leveraged-loan credit agreements

often require a certain agreed-upon

amount of excess cash to be used to

pay debt, but carve-out provisions

in recent credit agreements often

allow cash to be used for dividends,

investments, capital expenditures, and

other purposes before being included

in the excess cash flow calculation

that is used to determine the amount

for debt repayment.

Examiners have identified cases of

limited identification and assessment

of these types of underwriting and

credit agreement weaknesses, which

can minimize the efficacy of credit

risk grading, understanding of portfolio

risk, and appropriateness of loan and

lease loss reserves.

Loan Review

An effective loan review structure

serves to mitigate leveraged-lending

risk, and given the complexities and

risk inherent within a leveraged-loan

portfolio, the scope and independence

of the process is critical. A common

scope may include consideration

of the reasonableness of cash flow

projection assumptions, adequacy of

loan stress testing, compliance with

covenants, adequacy of enterprise

valuations, and ultimately the

accuracy of the credit rating.

Examinations have identified

instances in which loan review

frequency, depth, and quality has

been insufficient to provide a strong

independent assessment of credit

administration and underwriting

Supervisory Insights Fall 2019 FEDERAL DEPOSIT INSURANCE CORPORATION

Leveraged Lending

continued from pg. 15

relative to leveraged lending. Further,

in some other instances, loan review

staff or outsourced loan review

personnel were not trained to assess

the unique credit characteristics of

leveraged borrowers.

Syndications, Participations, and

Sub-Participations

Leveraged loans can be purchased

directly from agent banks or

indirectly through third parties

such as bankers’ banks or non-bank

financial institutions. Third-party

providers can provide smaller

investment amounts for IDIs, as well

as provide other fee-based services.

Third-party providers can also assist

with the risk management function,

generally for a fee, which can include

help with underwriting, risk rating,

enterprise valuations, and ongoing

credit review.

Outsourcing any risk management

function comes with risk, and

examinations have identified

situations where IDIs have become

overly reliant on the vendor. IDIs

are expected to maintain sound

vendor management programs

when purchasing leveraged loans

from a third party, which includes

independent analysis of each credit.

Management and Board

Oversight

The establishment of effective

risk tolerance, measurement, and

reporting is critical. Examinations

have identified instances in which

policies and procedures do not have

clear portfolio and capital limits on

the volume and type of leveraged

credits, including limits to any single

leveraged borrower. Examinations

have also identified instances in

which policies and procedures are

inadequate in terms of monitoring

and risk-ranking leveraged credits.

Summary

Leveraged lending presents

heightened risk for IDIs if internal

risk management programs are not

established and effectively managed.

Leveraged lending volumes, held by

banks and non-banks, have continued

to increase. As a result, regulatory

scrutiny of this sector will continue.

Gary L. Storck

Senior Large Financial

Institution Specialist

Division of Risk Management

Supervision

[email protected]

Mark D. Sheely

Senior Large Financial

Institution Specialist

Division of Risk Management

Supervision

[email protected]