If you plan on tapping the commercial bank market in 2015, bear in mind...

The Office of the Controller of the Currency’s (“OCC”) leveraged lending guidelines will undoubtedly effect how receptive commercial banks will be to your deal. The OCC originally revealed their Interagency Guidance on Leveraged Lending back in March of 2013; however, it wasn’t until the second half of 2014 that commercial banks really started to take note. Highly leveraged transactions (“HLTs”) are now facing increased scrutiny.

Defining HLTs

The OCC suggests that banks define HLTs as loans having the following characteristics:

• The use of proceeds is for a leveraged buyout, majority recapitalization or a dividend recapitalization;
• There is a substantial change in the capital structure as a result of the transaction; or
• Senior debt leverage is greater than 3.0x and/or total debt leverage exceeds 4.0x

If a loan meets the above criteria, then the borrower must be able to demonstrate the ability – a distinction from scheduled amortization – to 1) repay all of the senior debt over a five to seven year time period or 2) repay at least 50% of the total debt over a five to seven year time period.

The leverage threshold

The most frequently referenced point in the OCC’s report is the 6x leverage threshold, defined as total debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”). The OCC unequivocally states that HLTs with over 6x leverage will face a higher bar for completion. The point is emphasized enough throughout the report that some banks have begun to avoid those debt levels altogether.

That is not say that ALL banks will no longer underwrite HLTs. Rather, we believe most will simply adjust their internal policies to address OCC guidance while still allowing some flexibility for approving transactions that, on the surface, meet the HLT test. Most commercial banks have a designated basket for HLTs as a percentage of their total loan book, making this capital fairly scarce and highly selective, but not eliminating it completely.

Commercial banks therefore tend to be very selective on which HLTs to pursue. Companies with unknown sponsors or deals with a fair amount of “story” will encounter difficulty raising commercial bank financing regardless of leverage.

Essentially, the OCC is trying to make levered cash flow deals Other People’s Problems.

The state of the BDC

As banks continue to be judicious with their balance sheets, debt funds, many of which raised capital as business development companies (“BDCs”), are also pulling back. One of the primary drivers of the pullback was a 4th quarter decline in the market capitalizations of several public BDCs. With several of the larger BDCs trading below book value, their ability to tap the public equity markets for additional liquidity is limited, resulting in increasingly selective deployment process.

In 2014, multiple headline issues impacted BDCs, including:

• The SEC required funds that own BDCs to report fees as if they were their own even though BDC fees aren’t paid by the funds.
• Rather than report higher fees, the S&P and Russell indexes opted to remove BDCs from their widely followed funds.
• These indexes alone accounted for about 10% of outstanding shares of BDCs, so the de-listings pushed shares downward into the summer.
• Values eventually recovered, but the market hiccup in October, along with global growth and interest rate concerns, hit BDCs again during the 4th quarter.

In summary

In the near term, particularly in the lower middle-market (businesses with less than $50M of EBITDA), we anticipate both leverage and pricing to follow what we saw during Q4 2014. Commercial banks will continue to support deals and structures they can get comfortable with; however, the days of banks being in an absolute frenzy to put capital to work – like we saw in 2013 and early 2014 – are all but gone.

In contrast to their typical role of providing junior capital, BDCs will look to move up the capital structure to fill the void left by the banks. The scarcity of bank deals will likely allow BDCs to win first-lien deals, even with relatively higher pricing.

Debt capital will still be available to support LBO’s, corporate M&A, and dividend recapitalizations; however, finding the right lender will likely be more nuanced. Successfully navigating the debt markets in 2015 will require both real-time knowledge of comparable deals and an understanding of the capital bases of lenders. As always, we believe middle market debt is best accessed through a banker-led competitive process in order to maximize the probability of getting the best pricing, structure and terms available in the market.