LONDON The ECB's final guidance on leveraged loans will reshape the European market when it comes into effect in November, but several key questions have yet to be answered as the countdown begins.
The final guidance was broadly in line with the draft published last November but was tweaked after market feedback, bringing it more into line with US leveraged lending guidelines, although the ECB guidance is viewed as tighter due to the introduction of a new definition for failed deals.
"The guidance in the US and Europe is similar . . . but the ECB guidance is tighter in some respects," said Martin Forbes, a banking partner at White & Case.
The guidelines made some concessions, including allowing adjusted Ebitda and borrowers to show an ability to repay senior secured debt to a sustainable level in five to seven years rather than repaying 50% of total debt from cash flow. Certain types of deals were also excluded.
Several key questions are outstanding, including the definition of total debt and the impact of the regulation on acquisition finance and banks' internal systems due to the introduction of a tough 90-day limit for syndicating deals, according to a report by White & Case.
Under the final guidance, the definition of total debt now includes additional debt that loan agreements normally allow. It is not clear if this includes incremental, accordion or side-by-side loans and baskets and ratios for permitted debt, which are normally allowed in loan covenants even if they are never actually drawn.
Only committed undrawn liquidity facilities, such as commercial paper programmes, have been excluded, and the ECB has warned that care needs to be exercised when applying this exemption.
In a more radical departure, banks are now expected to treat deals that have not been syndicated within 90 days of signing as failed syndications for internal monitoring, booking, accounting, regulatory classification and capital requirements, which could change European banks' behaviour.
Many of Europe's commercial banks have a "buy and hold" mentality and hold stakes in their own deals until maturity, especially those loans made to domestic companies. The new rules could push them to align with US investment banks, which seek to sell down to zero to release and reuse their capital and reduce funding costs.
"We don't know exactly how the 90-day requirement for completion of syndication, after which syndicated deals should be treated as having failed, will be applied. The more tightly it's applied, the more the market will tighten," Forbes said.
The 90-day rule could have a big impact on merger and acquisition financing, which is usually agreed before deals are announced to provide certainty of funding. M&A deals can take months to close if they are referred to regulators and are often not fully syndicated until the M&A trade closes.
"In transactions where you have long competition clearance, divestments or other complications, this will unfairly penalise banks underwriting those deals," Forbes said.
It also remains to be seen how "failed" deals that have not been syndicated after 90 days will be allocated to lenders' hold books. Further guidance is required on how do this for acquisition financing and bids with interim loan agreements.
Investors are sometimes offered ticking fees to compensate them for their commitments until M&A loans are drawn. If lenders have to charge higher fees for tying up their balance sheets, acquisition loans could become more expensive for borrowers.
"In a situation where you have to set aside capital for a longer time, you normally have to compensate with a ticking fee. If banks are told to only lend to deals like this in exceptional circumstances, there will be fewer of those deals underwritten by European banks," Forbes said.
Shareholder loans and PIK loans will be included in total debt calculations, but it is not clear if this also includes subordinated shareholder debt, which is used to upstream cash in European leveraged finance.
Banks will also be required to verify leveraged loan pricing by a unit independent of the syndication team, and deals with credit, underwriting or settlement risk in syndication also need to be reviewed and approved by an independent risk function.
UNEVEN PLAYING FIELD
As in the US, banks are concerned that the guidance will create an uneven playing field that will favour institutions not regulated by the ECB, such as US, Japanese and (post-Brexit) UK banks.
"The US and ECB versions of the guidelines are at least similar, and some market participants are already subject to US rules. It is certainly significant and people will have to think about how they do things," said Andreas Wieland, a partner who heads White & Case's regulatory practise in Frankfurt.
Many institutions, particularly those with global operations, have been lending around the US guidelines, and national regulators are expected to take a similar approach to the ECB guidance.
"National supervisors will likely base their assessment of leveraged lending procedures on criteria similar to the ECB," said White & Case partner Stuart Willey.
Non-regulated lenders thrived in the US after its version of leverage lending rules was introduced and it is not clear how the ECB will react if an uneven playing field is indeed created. Although the guidance is not binding, the regulator expects institutions under its supervision to integrate the rules into internal credit processes and will intervene if this does not happen.
(Editing by Christopher Mangham and Matthew Davies)