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Wall Street Piles Leverage Onto Riskiest U.S. Buyouts

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The U.S. signaled to banks that risky loans are okay. Lenders are now listening.

Goldman Sachs Group Inc. and Citigroup Inc. are among the banks that have doused companies with debt to an extent that would have been almost unthinkable a year ago, at least for a regulated bank. They’re piling loans onto corporations that are being purchased in leveraged buyouts, and when the dust settles, companies like health care services provider Envision Healthcare Corp. could have total debt around 7.5 times a measure of earnings.

A year ago banks believed, with good reason, that regulators would view any ratio above six times as too high. Then in February of this year, government officials hinted that they were easing their enforcement of that guideline, and the entirely foreseeable came to pass. While average levels of indebtedness are only edging higher in acquisitions, leverage is jumping in the riskiest deals. Regulated banks are stepping into an area previously dominated by less-regulated foreign lenders and smaller investment banks.

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“Banks are beginning to push the envelope,” said Steven Oh, global head of credit and fixed income at PineBridge Investments in Los Angeles. “What had kept leverage muted had been the leveraged lending guidance,” he said, referring to regulatory guidelines for the loans.

Wall Street Pushes Leverage in Buyouts: Read the Weekly Credit Brief

And it’s not just debt levels: protections for investors in the more than $1 trillion leveraged loan market are weakening too. Looser strictures and safeguards will likely lead to bigger losses for debt investors whenever credit markets start to cool. Money managers including Pacific Investment Management Co. and BlackRock Inc. have been cutting back on their corporate debt exposure in part for this reason.

“Every week you come in and think they can’t get any looser, but they do,” said Frank Ossino, a senior portfolio manager at Newfleet Asset Management, referring to lenders and the terms on loans.

The higher debt levels are being fueled in large part by greater borrowing in the loan market. About 34 percent, or $171 billion, of all institutional loan launches so far this year through Tuesday have been to finance takeovers, buyouts, or dividends. That figure was closer to $160 billion at the same time last year.

KKR & Co.’s $8.3 billion purchase of BMC Software Inc. will increase debt levels levels at the information technology firm to about 7.5 times of earnings before interest, taxes, depreciation and amortization, or “EBITDA,” according to people familiar with the transaction, who asked not to be identified because the matter is private. That comes just two years after an earlier debt deal at the company drew a warning from regulators over risks. Lenders in that deal include Credit Suisse Group AG and Goldman Sachs, which both declined to comment.

Another KKR buyout deal, for Envision Healthcare Corp., will also have leverage of about 7.5 times, people familiar with that deal said. Lenders including Citigroup and Credit Suisse, both of which declined to comment.

And Vertafore got a debt financing last week including a $1.6 billion loan that increased leverage at the software company to about the same level, according to separate people familiar with the matter. Moody’s Investors Service put the leverage even higher at 10 times, following the company’s plan to pay a “large distribution to shareholders” with proceeds.

Representatives at the software firm didn’t immediately respond to a request for comment. Representatives for Nomura Holdings Inc., which led the financing and isn’t subject to U.S. regulated-bank guidelines for leveraged lending, declined to comment. Representatives for Bain Capital, which along with Vista Equity Partners agreed to buy Vertafore in 2016, also declined to comment.

Long-Term Trend

Leverage levels had been showing signs of edging higher even before regulators loosened their enforcement. The U.S. Treasury Department released a report in June 2017 that recommended banks look at a broad array of metrics when underwriting a leveraged loan, and not just focusing on the 6 times ratio. As of September 2017, about 6% of LBO’s had 7 times or more debt than Ebitda, about double the year before.

Morgan Stanley said in a report Friday that leverage is at an all-time high in newly made U.S. loans known as first-liens, whose holders have first priority if the company fails. Borrowers of such loans had debt equal to a record 4 times a measure of earnings in the first quarter, up from 3.92 times at the end of 2017, the report showed. It’s also rising in high-yield bonds, the bank’s analysts said.

For buyouts, lenders often talk down the importance of leverage by emphasizing how measures of indebtedness will fall in the future, because of, for example, higher earnings before interest, taxes, depreciation and amortization. That shows up in “add backs,” or adjustments to Ebitda.

High leverage levels are less concerning when corporate capital expenditure is low, freeing up cash to pay off debts. Certain industries like software firms Vertafore and BMC also throw off recurring cash-flow, due to the likelihood customers don’t switch providers.

Edging Higher

And deals with high debt are still not the norm. Average leverage has been edging higher but remains below the six-times metric for the broader market looking at M&A-linked deals in the last three months, according to research firm Covenant Review.

Regulators say they have other ways to rein in risky lending practices, and that they are keeping a watch on debt ratios. Federal Reserve Chairman Jerome Powell said Wednesday he’s watching leverage levels closely at non-financial companies. The six-times rule is not and never was a ceiling, and in guidance released in 2014, the Fed and other regulators said they consider all underwriting factors when reviewing credits.

The guidance applied only to regulated banks, which shifted leveraged lending — along with its risks — into the domain of so-called shadow banks. Most of the “really high” leveraged-lending activity in the current cycle is being done by private-equity firms, not banks, said Joseph Otting U.S. Comptroller of the Currency, on Wednesday.

But still, banks feel emboldened after comments from regulators earlier this year. The lenders aren’t ignoring all rules of common sense, but they are pushing the limits a little, said Christopher Remington, a portfolio manager at Eaton Vance.

“It has been a year where demand has outstripped supply. That has made it an issuer’s market,” he said. “It’s very normal to see degradation in credit statistics late in the cycle. And it is late in the cycle.”

—With assistance from Kiel Porter.

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