* Non-bank lenders could gain from ECB leverage rules
* US trend towards self-syndication may come to Europe
* Opportunities for regulatory arbitrage abound
By Robert Smith
LONDON, Jan 3 (IFR) - Proposed leveraged lending guidelines
from the European Central Bank could force riskier lending into
unregulated channels and create unintended opportunities for
arbitrage as well as breed market distortion.
In an attempt to curb banks from underwriting riskier LBOs,
the European banking watchdog has put forward a red line of 6x
leverage in its draft guidance on "leveraged transactions",
closely mirroring guidelines introduced by US regulators in
Fears are growing, however, that Europe could see similar
unintended consequences to the US, where the introduction of the
threshold has driven highly leveraged lending underground.
"It's a bit of a game of whack-a-mole, because not only will
the non-bank lenders step into the breach and provide larger and
larger loans, but what we've seen happen in the US is that the
banks have actually stepped up their lending to these private
credit institutions," said Luke McDougall, a leveraged finance
partner at Paul Hastings.
US private credit and direct lending funds once specialised
in mid-market buyouts. However, they have raised enough
firepower in recent years to supplant the institutional
high-yield bond and leveraged loan packages typically required
for large-cap deals, such as Thoma Bravo's US$3bn take-private
acquisition of data analytics firm Qlik Technologies in
A senior manager at a London-based credit fund that
specialises in direct lending said the ECB's proposed rules
would only hasten the debt market's shift into "unregulated
"It makes no difference to us whether a deal is publicly
syndicated or not, but if I was on the cap markets desk at a
bank, I'd be worried," he said. "You're only going to see more
and more self-syndicated deals."
Private equity firms in the US are already cutting out banks
to syndicate LBO debt themselves, a phenomenon KKR spearheaded
on its Mills Fleet Farm buyout at the end of 2015.
One leveraged finance banker said that direct lending funds
are already targeting more highly leveraged transactions than
banks, irrespective of the ECB's new regulation, however.
"The return hurdles these guys originally set are getting
harder and harder to achieve - the only way they can do it is
pushing the needle on leverage," he said.
And a second banker said he thought that concerns around
leverage were "neither here nor there", as there is "no
regulation on any terms" in the direct lending market.
"There is a broader concern that those kinds of products are
underpricing illiquidity, so it'll be interesting to see how
they perform over the course of the credit cycle," he added.
"They're going very well in terms of raising money and
building assets right now, but when you've lent 8x levered money
to a small business and the credit cycle starts to turn, you
could see those liquidity issues come to the fore."
Another concern is that guidelines will create scope for
regulatory arbitrage, with lenders willing to provide more
aggressive terms elsewhere to compensate for lower leverage.
The US has seen some banks make larger and larger
adjustments to companies' earnings in order to comply with the
6x leverage threshold, rather than eschewing riskier deals.
The Federal Reserve last month reprimanded underwriters of
mixed martial arts franchise the UFC's LBO, according to press
reports, for making large add-backs to Ebitda to comply with the
"We're getting to the point now where the definition of
Ebitda is going to have to be regulated," said one high-yield
"I have no doubt this resulted from the regulation on
leverage; the quid pro quo has been more aggressive use of
The ECB has already looked to head off some of the abuses
seen in the US, explicitly stating in its draft that its
leverage thresholds are based on "unadjusted Ebitda".
But private equity firms, no longer able to leverage
companies as high as they would like to initially, can simply
pressure underwriters to give them greater flexibility to do so
"The sponsor-friendly movements we've seen in Ebitda
adjustments are not primarily on out-of-the-box leverage, as
that tends to be heavily diligenced, but more on aggressive pro
forma allowances around future actions," said McDougall.
"Sponsors are also pushing for looser and looser debt
incurrence covenants, meaning a deal could be compliant on day
one but have headroom to lever up on day two."
Trying to grapple with these minutiae of leveraged finance
documentation could create even more headaches for the ECB.
"It's very difficult for regulators to account for events
that have not happened yet," McDougall added. "And if they're
more proscriptive, it will only produce even more opportunities
(Reporting by Robert Smith; Editing by Helene Durand and Philip