RLPC/IFR: Riskier financings persist amid regulatory warnings

NEW YORK Wed Jan 15, 2014 4:37pm EST

NEW YORK Jan 15 (Reuters) - Banks are becoming increasingly selective about which highly-leveraged U.S. company loans they are willing to underwrite as they start to heed regulators' warnings to curb looser lending practices.

Investor demand for deals that regulators view as risky, including a $1.1 billion loan for software maker Applied Systems , shows no signs of abating, but banks are looking at new transactions more carefully to try to avoid raising red flags with regulators.

U.S. market watchdogs are trying to clamp down on loans with higher leverage levels and dodgier repayment prospects, seeking to avert the problems emanating from the mortgage market that spurred the last financial markets meltdown and recession.

Regulators sent letters in late 2013 to banks warning that they were not following leveraged lending guidelines that were updated in March for the first time in a dozen years.

The guidelines increased the number of loans deemed to be leveraged on banks' books. Banks have to hold more capital to buffer potential losses on riskier assets, which could restrict new leveraged loans that lenders are able to underwrite.

"We've passed on deals that have gotten done in the marketplace, that don't meet or do meet the guidelines, and I'm sure we've done deals that others have passed on," a banker said. "Good deals will continue to get done. We take credit views and client views."

Loans can be categorized as "criticized" if companies are not able to to amortize or repay all of their senior debt from free cash flow or half of their total debt in five to seven years.

Leverage levels exceeding six times Debt to Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) after asset sales are also viewed as problematic.

NEW FOCUS

Banks are now focusing on companies that are able to meet the criteria to avoid deals being criticized. They are still prepared to underwrite some riskier loans but are now picking the deals that will go against the guidelines more strategically.

"The regulators have said that they expected deals to be rare in occurrence. The banks are all grappling with how many are acceptable and what rare is," a second banker said.

Banks are already rejecting deals based on their leverage profile after considering whether the deals will meet the guidelines, sources said.

Fewer banks willing to underwrite new highly leveraged deals could discourage private equity firms that are trying to raise buyout financing and impact M&A volume.

"Sponsors will have to go to more banks to find takers," a third banker said.

Loans that finance dividend payments to private equity firms are expected to be hit, along with loans for middle-market companies that generate less fees.

Large fees may tempt some banks to underwrite highly-leveraged loans despite the guidelines, but there likely will be less competition for these deals.

"Fees will definitely play a factor. If a bank is made a 50 percent bookrunner and there is a meaningful fee, then they might do it, but if they're not and it's a non-pass from the regulators, then it becomes more doubtful," a fourth banker said.

MARKET APPETITE

Buyout loans that could be considered criticized under the guidelines are still seeing overwhelming demand from asset-hungry investors as cash continues to pour into loans. Investors are piling on to floating-rate assets with the Federal Reserve's tapering of its massive bond buying program seen leading to rising interest rates.

Highly leveraged loans including the $1.1 billion loan backing Applied Systems' purchase by private equity firm Hellman & Friedman and a $3.7 billion loan financing the Carlyle Group's purchase of Johnson & Johnson Inc's ortho clinical diagnostics are being carefully watched in the market.

With debt of roughly eight times EBITDA, Applied Systems is the most highly levered transaction since the financial crisis, sources said. Although this could mean that the deal fails regulators' tests, it has already proven popular with investors.

Orders from investors topped $5 billion - nearly five times the size of the financing - on January 10 before the commitment deadline and pricing was also cut, sources said.

Applied Systems is seen as a strong credit and has shown an ability to deleverage by reducing debt, which is leading investors to question whether the deal would fail regulators' criteria, the sources added. The loan price rose once it entered the secondary market on Wednesday, traders said.

"People are happy doing 7.9 times total leverage, more so for this company (Applied Systems) than they are doing 5.9 times or 6.9 times for most other companies," the second banker said.

The $3.7 billion financing backing private equity firm Carlyle Group's $4.1 billion to $4.5 billion purchase of Johnson & Johnson Inc's ortho clinical diagnostics could also run afoul of regulatory guidelines.

The acquisition deal, which has expected leverage of around six times, is seen being signed by Friday, although could be delayed, bankers said. Barclays and Goldman Sachs are leading the deal.

Credit Suisse, Goldman and Barclays declined to comment.

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