Leveraged loans deserve another look from banks

Many banks curtailed leveraged lending following the financial crisis, and for good reason. But we may be on the verge of a leveraged-loan comeback.

The $800 billion-plus domestic market for leveraged loans has been around for almost 30 years, and has been a way for banks to expand their commercial and industrial loan portfolio, even without maintaining relationships with commercial borrowers. Leveraged loans are often structured as syndicated credits, in which multiple banks hold loan participations.

But the market’s condition deteriorated in the crisis. Like many other bank assets, leveraged loans became stressed. Default rates spiked to over 10% by 2010. Regulators subsequently signaled a hostile view of leveraged loans in 2013 guidance calling for stronger risk management and underwriting. Consequently, many C&I lenders abandoned such deals.

Nonbank direct lenders, business development companies, collateralized loan obligation funds and private equity affiliated debt funds all capitalized on the banking retreat. They funded acquisitions and private-equity buyouts as the M&A market rebounded. This direct-lender disintermediation is especially evident in the middle-market debt segment. Ironically, the warehouse capital needs of these direct lenders are funded by banks.

But the tide might be turning.

The time may be right for banks with middle-market C&I lending platforms to reconsider leveraged loans for several reasons.

First, acquisitions and buyouts, the prime driver of leveraged loan demand, are expected to grow. Furthermore, private equity has record levels of capital to invest, making an increase in leveraged buyouts even more likely. Meanwhile, regulatory policy dealing with leveraged loans appears to be moderating.

Not only is the regulatory environment becoming generally more favorable to banks, but in its fall 2016 semiannual risk report, the Office of the Comptroller of the Currency changed its characterization of leveraged lending to an issue warranting continued monitoring from a key risk. In addition, Sen. Pat Toomey, R-Pa., is exploring whether the regulators’ 2013 leveraged lending guidance is subject to the Congressional Review Act, which in certain cases allows lawmakers to roll back regulatory policies.

Finally, leveraged loans in the current market environment are more conservatively structured, with higher equity levels (lower leverage), than they were in the pre-crisis period.

But the more favorable conditions for leveraged lending do not mean banks should resume becoming active in the market just like they did before.

The focus should be on originating transactions with relationship-orientated clients, not passive participations in syndicated credits. Banks should understand the risks, get comfortable with the cyclical risk-return dynamics, and acquire the requisite skills to manage the transaction and portfolio risks involved. This requires an investment in infrastructure, especially experienced professionals, for underwriting, origination, due diligence and portfolio monitoring.

The key is the consistent application of clear underwriting standards to avoid excessively leveraged transactions. Leveraged loans, while fully secured, are cash-flow based. This requires an evaluation of the obligor’s prospective earnings before interest, taxes, depreciation and amortization under plausible operating scenarios, relative to debt. The results should demonstrate an ability to service debt, including reasonable amortization. Next, portfolio guidelines including the size, concentrations and portfolio growth are necessary. This includes monitoring systems to track credit performance such as covenant compliance.

There are important structural differences between traditional middle-market C&I loans, and leveraged loans. First, leveraged loans have a limited number of financial covenants. This difference may be more cosmetic than real. Additionally, leveraged loans frequently lack full collateral coverage.

Leveraged loans are not for everyone given their risks. Nonetheless, the possible moderation of regulatory headwinds and the expected increase in M&A and private equity transactions warrant banks giving leveraged loans another look. This could be an option for well-capitalized banks seeking to complement their traditional C&I and real estate lending efforts. Discipline, relationships and infrastructure investment are critical for the successful long-term execution of the strategy.