Leveraged Lending

Credit Risk

Credit risk is the current and prospective risk to earnings or capital arising from a borrower’s failure to meet the terms of any contract with a bank or otherwise to perform as agreed. Credit risk is found in all activities where success depends on counterparty, issuer, or borrower performance. It arises any time bank funds are extended, committed, invested, or otherwise exposed through actual or implied contractual agreements, whether reflected on or off the balance sheet.

High debt levels increase the risk of default. Leveraged borrowers’ higher debt levels relative to their equity, income, or cash flow make it more difficult for the borrower to withstand adverse economic conditions or business plan variances, to take advantage of new business opportunities, or to make necessary capital expenditures.

The primary source of repayment in all leveraged transactions is the borrower’s ability to generate a satisfactory level of cash flows. Secondary sources of repayment include refinancing, recapitalizing, or restructuring of debt through the sale or disposal of the company assets or stock. When the borrower’s use of increased debt does not generate sufficient cash flows or asset values, both primary and secondary repayment sources may be quickly and seriously impaired.

Leveraged transactions, in general, are characterized by a high level of debt, increased volatility of corporate earnings and cash flow, and limited avenues of secondary support. In addition to these more general factors, other features in leveraged lending activities heighten credit risk, and warrant more intensive risk analysis, monitoring, and management. These factors include:

Debt Structures and Collateral. Leveraged loans are typically structured with a revolving credit facility and several term loan tranches with successively longer repayment terms. The revolving debt portion may be secured by a traditional borrowing base of working assets, with the term tranches collateralized by available business assets and stock. Leveraged transactions are often characterized by a reliance on enterprise values and a financing gap between the value of the collateralized assets and the amount of the loan. As overall debt levels increase, the borrower’s needs exceed conventional collateral advance formulas. In such cases, working capital assets will be used to secure long-term debt, fixed asset collateral will secure revolving facilities, and, as a result of these two events, the financing gap, that is, the amount of the loan not supported by collateral may widen. These practices dilute the lender’s overall collateral protection. In many cases, these structured transactions contain cross collateralization and cross-default provisions, which further dilute collateral protection for each component.

Repayment Terms. Longer tenors, deferred or back-ended principal amortization and single payment notes are increasingly common in leveraged lending structures. In many cases, the economic benefit of the asset or transaction financed with increased leverage will not be immediately realized by the borrower. As a result, principal repayment requirements are deferred or otherwise set to coincide with the realization of expected repayment sources. This often occurs when lenders finance capital intensive or expanding businesses that must invest significant amounts of cash to fund long-term capital investments. It also occurs when lenders finance merger and acquisition activities, and in transactions where asset prices and business valuations are unproven or increasing relative to historical income and cash generation capability. Longer tenors can be appropriate when they are coordinated with the economic use and value of the asset or transaction financed, as well as with the level and timing of expected cash flows. However, they are not appropriate when used to mask credit weaknesses related to the borrower, liberalize repayment terms for projects that have been "over-financed," or provide permanent capital.

Reliance on Refinancing or Recapitalization. Lending and equity markets can be volatile. When markets are liquid, reflecting strong demand by banks and institutional investors for loan assets, and attractive conditions for firms to issue equity, many borrowers negotiate deal structures that rely on loan refinancing or a capital issuance as the primary repayment source. Often, there is no clearly defined or realistic alternative source of repayment. Loan arrangements that rely on refinancing or equity issuance in the capital markets carry the added element of market risk. Market liquidity and receptiveness can dissipate quickly for reasons beyond the control of the lender or borrower and rapidly elevate risk.

Reliance on “Enterprise Value” and “Airballs.” Enterprise value, which is basically the estimated value of the borrower as a going concern, is typically used by banks to support leveraged lending arrangements when committed amounts exceed the borrower’s underlying tangible asset values. Historically, these under-collateralized positions, or “airballs,” have included accelerated or prioritized repayment, or have been held by subordinated lenders. Enterprise values can be highly volatile as they are subject to influences both within and beyond the control of the parties (e.g., interest rates, conditions in the industry, economy, or capital markets). Valuations depend on management’s ability to achieve revenue and expense projections, and are difficult to fully support. Moreover, enterprise value is especially susceptible to decline when most needed by the lender, e.g., in problem situations or in an economic downturn.

Interdependent Repayment Sources. Leveraged loans are often underwritten with collateral liquidation, asset sales, refinancing, or recapitalization as secondary sources of repayment. The value of such secondary sources is often directly linked to the strength of cash flow. Hence, their value may diminish in tandem with cash flow, thus increasing the risk of loss in the event of default. Risk is increased even further when both primary and secondary repayment sources depend on achieving performance levels (sales, income, cash flows, asset values, etc.) above those demonstrated historically.

Reliance on Equity Sponsors and Agent Banks. Some banks participate in leveraged loan transactions based on the strength and reputation of equity sponsors. They believe that major equity sponsors will support their transactions (e.g., provide additional equity, halt dividends, further subordinate rights to senior lenders) in order to protect their investments and reputations. Lenders sometimes place too much reliance on this informal support. The sponsor’s primary obligation is to support its investors by enhancing profits, cash flow, and, ultimately, the value of the company. Its ability to provide additional support is limited by the firm’s legal charter, its financial capacity, and its economic incentive to support the company.

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