Leveraged Lending

Evaluating the Borrower in a Leveraged Loan Transaction

As in all loans, the credit evaluation of the borrower involves a thorough understanding of the purpose and terms of the credit, the borrower’s capacity to repay, and the quality of secondary repayment sources. Proper evaluation of these fundamental elements is also critical to the proper assessment of both transactional and portfolio risk in a leveraged transaction.

Understanding the purpose of the leveraged financing is the first step in evaluating the credit. A leveraged structure often signals potential increases in expected income sources, or gains in operating efficiencies or synergies. For instance, a transaction involving the merger or acquisition of a company may contain assumptions about potential synergies from the elimination of duplicate fixed costs, tax benefits, gains in managerial and human resource skills, and enhanced revenue opportunities. Alternatively, dividend recapitalizations or stock buyouts are transactions aimed primarily at increasing investor return or guarding against outside acquisitions, and substitute debt for equity. They generally do not signal enhanced revenue or operating efficiency opportunities.

Credit structure and repayment terms are often influenced by projected earnings performance, investor and market demand, and secondary support coverage. In other words, the timing of expected cash flows, investor repayment preferences, and the existence and life of collateral support will affect repayment terms. Competitive factors arising from robust market liquidity generally create more liberal repayment structures, while tightened market liquidity may allow banks to obtain more conservative covenant and repayment requirements from borrowers.

Regardless of these market shifts, it is important to understand the borrower’s complete debt structure and contractual demands, priority levels, and repayment capacity in all market conditions. Bankers and examiners need to incorporate the entire leveraged lending structure into their loan quality analysis and to evaluate cash flows, working assets, and other collateral against all the debt they support. They should analyze collateral values, advance rates, and cross-collateral and cross-default agreements within the context of repayment sources, schedules, and priorities, under both normal and stressed conditions.

The assessment of the borrower’s capacity to repay requires a thorough review of past operating performance and an understanding of the key drivers to achieve future operating projections. Cash flow sources must be weighed against cash needs on a recurring basis. Revenue and expense projections should avoid overly optimistic or unsubstantiated assumptions. The borrower’s ongoing cash needs should include provisions for all recurring charges commensurate with the business model. This includes expenditures for the maintenance of fixed assets, tax liabilities, dividend payout expectations, and realistic repayment programs.

Examiners should expect leveraged loans to have reasonable terms and be repaid within reasonable time frames. Examiners should also carefully review uses of cash by the borrower to ensure that funds anticipated to amortize debt are not used for discretionary purposes (dividends, distributions, repayment of subordinate debt, capital expenditures, etc.) at the expense of debt repayment.

Examiners should analyze the extent to which primary and secondary sources of repayment are related in order to assess both the risk of default and the risk of loss in the event of default. Special attention should be paid to loans where repayment relies on projected cash flows, profits, or asset values that exceed historical levels. Both historical and projected factors must be considered in the evaluation of expected borrower performance. These performance, repayment, and collateral value projections should be thoroughly evaluated for reasonableness and stress tested, both at loan inception and on an ongoing basis. This includes comparing actual performance with projections and identifying the reasons for significant variances.

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