| NEW YORK, June 10
NEW YORK, June 10 Wall Street banks are playing
cat-and-mouse with U.S. regulators over rules that seek to
reduce lending for deals that load up companies with too much
debt, as they try to retain a profitable business and meet
demands from clients and investors.
Leveraged lending is one of the most lucrative forms of
loans for banks, giving Wall Street an incentive to accommodate
borrowers as much as it can. Banks fees on U.S. junk-rated loans
stand at $4.9 billion so far this year, a year-to-date record
and up 10 percent from the same period last year, according to
Thomson Reuters and Freeman Consulting data.
The guidelines, issued by the Federal Reserve, the Office of
the Comptroller of the Currency and the Federal Deposit
Insurance Corp in March last year, generally seek to restrict
banks making loans in deals such as leveraged buyouts that would
leave a company with debt levels that are more than six times
its annual cash flow. Since the guidelines were issued,
regulators have warned lending standards have in fact
As a result, banks are exploring whether they can arrange
more of special kinds of bonds for companies that should not be
taking on more loans under the guidelines, according to banking
sources who spoke on condition that neither they nor the banks
they work for or with are identified. These bonds would help to
split the overall debt load between a holding company and its
operating subsidiary. The guidelines are aimed at curbing risky
loans and do not directly address bonds.
"There are a lot of smart, creative people out there that
are looking for ways to both meet demand from borrowers and
investors and satisfy regulators," said David Brittenham, chair
of law firm Debevoise & Plimpton LLP's finance group.
Banks including JPMorgan Chase & Co, Bank of America
Corp and Credit Suisse Group AG all have big
leverage finance businesses.
The loans are also important for buyout shops such as KKR &
Co LP and Apollo Global Management LLC, which
often use debt to magnify their returns. These firms have warned
in regulatory filings that the guidelines could erode returns in
their private equity business because of limits in how much
their companies can borrow.
One illustration of the guidelines' effect came last month,
when some of KKR's closest banking relationships snubbed a
request for a buyout loan over concern it is too risky to pass
muster with U.S. regulators.
Regulators, which are now reviewing banks' loan books to
assess their credit quality and compliance with the guidelines,
declined to comment on the workaround strategy.
A source familiar with the OCC's thinking said the agency is
likely to crack down on strategies such as the use of holding
company bonds that it thinks are meant to circumvent the
guidelines and could lead to a bank getting fined. The feedback
banks have received from regulators on the idea has been
negative, other sources said.
The deliberations show the challenges regulators face in
implementing financial reforms and curtailing the side effects
of the Fed's cheap money policies six years after the financial
crisis. By aiming for the most indebted companies, regulators
are trying to reduce risk in the banking system as well as in
the broader economy.
Perhaps the most infamous instance from that era was the $48
billion leveraged buyout of Texas power utility Energy Future
Holdings in 2007, the biggest LBO in history. The deal's $40
billion debt was equal to 8.2 times adjusted EBITDA (earnings
before interest, tax, debt and amortization). Energy Future
filed for bankruptcy earlier this year.
For investors, junk bonds have been one way to find returns
at a time when interest rates remain at record lows.
Banks are still trying to figure out how many deals that do
not comply with the guidelines they will be allowed to do, the
sources said. Regulators have told banks that these deals should
be rare, but it is unclear what that means, they said.
For example, "rare" has been interpreted as anything from
one or two deals a year to one or two percent of deals a bank
does, the sources said. Banks are hoping that the regulatory
review of their loan books will provide some clarity this
The sources said allowance for a certain number of deals
will also make putting together a lending syndicate for
non-compliant financings challenging.
That's because every bank wants to be the lead arranger on a
deal, which entitles it to most of the financing fees. The lead
bank in a syndicate may be happy to use one of its allowances
for a non-compliant deal, but will then have to persuade other
banks to also use their allowance for a smaller cut of the fees,
the sources said.
These challenges make the possibility of engineering a
workaround even more attractive for banks. The idea contemplated
takes advantage of the legal division of a company between an
operating company that owns the physical assets and runs the
day-to-day operations, and a holding company, which owns the
equity in the operating company.
Companies typically borrow at the operating company level
through loans. Since the loans can be secured against the
company's assets, they are cheaper than other options.
They can also borrow through the holding company by issuing
bonds. Payments on those securities are made from the cash that
remains after the liabilities of the operating company are met,
making them riskier than operating company loans.
Many holding company bonds are structured as payment-in-kind
(PIK) notes that pay interest by adding to the outstanding
principal rather than returning cash to the bond's holder - an
even riskier proposition.
Such bonds are expensive for the issuer and the risk
involved makes the investor universe limited, but the market has
been growing as investors seek higher-yielding securities.
By having the holding company issue PIK notes, financiers
hope they can appease regulators concerned about the drag of
more debt on the cash flow of a company. It remains unclear
whether regulators will be convinced, given their preliminary
Bankers point to a recent deal as an example of how that can
work. In March, alternative asset manager Crescent Capital Group
LP invested in PIK notes of Catalina Marketing Corp, owned by
rival Berkshire Partners LLC, according to a source familiar
with that deal.
Catalina's overall leverage reached 7.5 times EBITDA,
according to Thomson Reuters Loan Pricing Corp. But the
operating company leverage remained at 6.5 times EBITDA.
Credit rating agencies took the view that the move to issue
PIK notes was positive for operating company creditors because
they would not draw on Catalina's cash.
Berkshire Partners and Crescent Capital declined to comment
on the motives for that deal. Sources close to the transaction
said the bonds were aimed at giving more financial flexibility
to the operating company rather than to circumvent the
(Additional reporting by Mariana Santibanez and Natalie Wright
in New York; Editing By Paritosh Bansal and John Pickering)