Regulatory agencies’ failure to limit leverage is widely understood to have contributed to the recent financial crisis. It is a mistake that regulators do not want to repeat. In March 2013 the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp jointly issued guidelines that discourage banks from making loans that would raise the debt level of a company above 6 times earnings before interest, taxes, depreciation and amortization (EBITDA).
PE funds typically use very high levels of debt—so-called leveraged loans—to take over a company in a leveraged buyout. And these limits on excessive bank lending put a crimp in the PE model. PitchBook PE News reported on May 22 that “deals financed above 6.0 [times] have dropped significantly” since 2014. But that situation may be about to change.
To the consternation of the Financial Stability Oversight Council (FSOC), affiliates of PE firms such as KKR & Co. and Apollo Global Management are now getting into the business of making leveraged loans—mainly to PE funds bent on loading up the companies they acquire with debt. “Safe and sound leveraged lending activities” by banks are being circumvented by risky leveraged loans from unregulated nonbank entities that often have ties to PE firms and are not subject to supervision by bank regulators. However, these nonbank lenders get the funds they lend out in part by borrowing from banks, putting the banks at risk if the economy falters and companies with excessive debt default on these leveraged loans.
The use of debt financing to acquire companies accelerates profits and is high during good times, when the value of assets that can be used for collateral is high and measured risk appears to be low. And, indeed, the leveraged loan default rate is currently below its historical average, though the massive defaults of Energy Futures Holdings a year ago and Caesar’s Entertainment this year might serve as a reminder of what can happen. In a downturn, of course, the excessive use of leverage will exacerbate the effects of the economic contraction and threaten the viability of companies with high debt burdens.
This is what concerns the FSOC. If the economy slows and these risky loans sour, then the banks that made funds available for these highly leveraged will be in jeopardy.
The Financial Stability Board (FSB), the global financial regulator, has stepped into this regulatory void. The FSB is led by Bank of England Governor Mark Carney and includes the U.S. Federal Reserve, Securities and Exchange Commission, and Treasury. It has proposed a plan to identify global funds and asset managers that should be designated as systemically important financial institutions; that is, as institutions whose failure could cause or amplify serious damage to the financial system.
Large investment funds object to such a designation since it comes with heightened scrutiny and regulatory requirements intended to assure the stability of the financial system in stressed conditions. But with nonbank entities in the shadow banking system getting into the business of risky leveraged lending using funds borrowed from banks, such regulation appear necessary for the safety and stability of the banking system.