Key Regulatory Issues Affecting Leveraged Loan Market Meredith Coffey, LSTA mcoffey@lsta.org 212-880-3019 1
On The Agenda Today. Key Leveraged Loan Market Segments and How They re Affected by Regulation Impact of Regulation How the Regulatory Environment Might Change 2
A (Non-Comprehensive) List of Regulation Impacting the Leveraged Loan Market Leveraged Lending Guidance Prohibits non-pass originations, requires significant classification, reporting and testing Risk Retention Requires CLO managers to put significant capital into deals Mutual Fund Liquidity Risk Management Requires liquidity risk management Volcker Rule Effectively prohibits CLOs from investing in any bonds FDIC Assessments Requires banks to treat CLO AAA notes like leveraged loans Tax Reform??? Might remove interest deductibility 3
Impact of Regulation on Leveraged Loan Market Leveraged Lending Guidance, (Tax Reform?) Other, $299 CLOs, $447 Risk Retention, Volcker, FDIC Assessments Loan Mutual Funds, $154 Liquidity Risk Mgt Source: TR-LPC 4
Leveraged Lending Guidance 5
Leveraged Lending Guidance Leveraged Lending Guidance was issued by OCC, Fed and FDIC in 2013 Banks cannot originate non-pass credits Generally viewed as loans to companies that cannot show the ability to repay all senior debt or half of total debt in 5-7 years from base cash flows Casts a skeptical eye on EBITDA adjustments, incremental baskets There is not a prohibition on underwriting loans with leverage > 6X Includes significant reporting requirements, including for non-leveraged loans swept up into the leveraged definition 6
Leveraged Lending Guidance: Accelerated the Rise of Non-Bank Originators and Direct Lenders 2016 LBO League Tables by Volume 2016 LBO League Tables by Deal Count Bank Share 76% Non-Bank Share 24% Bank Share 67% Non-Bank Share 33% Source: TR-LPC Increasing non-bank share in LBOs Increasing direct lending 7
Leveraged Lending Guidance: Leverage Levels Avg. LBO Debt/EBITDA Fewer LBOs Have High Leverage 7 70% 6 60% 50% LBOs with Lev >=7x LBOs with Lev >=6x Leverage (x:1) 5 4 Share of LBOs (%) 40% 30% 20% 3 LC LBO Debt/EBITDA 10% 0% 2003 2005 2007 2009 2011 2013 2015 1Q17 2 MM LBO Debt/EBITDA 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 1Q17 Source: S&P/LCD LBO leverage levels are near post-crisis highs, but share of LBOs levered >= 7x remains low However, adjustments have increased, increasing the gap between reported and adj. EBITDA 8
Risk Retention 9
Risk Retention and CLOs Risk Retention Rule went effective for CLOs on Dec. 24, 2016 CLO managers must now purchase and retain 5% of any new CLO they do For a $500 million CLO, this is $25 million Choosing not to quietly go out of business, CLO managers have spent several years developing sources of capital CMVs, MOAs, mergers with capital rich entities Risk retention financing? SEC s Crescent No Action Relief Letter permits CLOs issued prior to Dec. 24, 2014 to refinance without retaining risk with material constraints Must be within 4 years of issuance Can only refinance once Cannot make any changes other than reducing spread Refis vs. resets Crescent refis can be done without risk retention (for CLOs issued before Dec. 24, 2014) Resets can make any kind of changes (such as extending tenors, changing spreads), but require risk retention 10
CLOs: Annual Issuance Trends $140B Annual CLO Issuance $120B $100B Est Issuance (Billions) $80B $60B $40B $20B $0B 2012 2013 2014 2015 2016 2017 U.S. CLO issuance peaked in 2014 Following the release of the risk retention rules, CLO managers spent several years working to find capital CLO issuance fell 40% between 2014 and 2016; expected to recover somewhat this year Source: S&P/LCD 11
CLO Activity: Issuance, Refis and Resets CLO Issuance, Refis and Resets 25 20 15 CLO Resets CLO Refis CLO Issuance 10 5 - Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 After quiet January, new CLO formation rebounded as managers utilized the risk retention capital they had raised Refinancings (under the Crescent letter) surged in order to bring down CLO liability costs Resets beginning to pick up Source: TR-LPC 12
What Has Changed Since the 2016 GFMI Conference? 13
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Four Avenues for Regulatory Changes Legislative Fixes Less likely because the Republican majority in the Senate is so narrow Legal Challenges Timeframe for most Dodd-Frank challenges has passed Executive Orders Sets the framework in which regulators/ administration should work Regulatory Fixes Regulators themselves could change rules through new rulemaking, guidance or refining enforcement 15
Executive Order and Treasury s Report on FinReg In February, President Trump signed an Executive Order laying out Core Principles for FinReg, and requiring Treasury to prepare reports on how to conform regulation to the principles In early June, Treasury issued its first report under the February 3 rd Executive Order on Financial Regulation There are several issues that are key to the leveraged loan market Leveraged Lending Guidance Volcker Rule (on covered funds and CLOs) 16
Treasury s Reports: Next Steps The June Treasury report was the first of at least four reports Upcoming Treasury reports slated to include i) capital markets, ii) asset management and insurance industries, and iii) non-bank financial institutions What happens next? New regulatory heads must be nominated and confirmed Comment or rulemaking would be required for some of Treasury s recommendations Due to this process, any FinReg refinements are likely to be 2018 (or later) events 17
Leveraged Lending Guidance Change? Congressional Challenge Under the CRA Congressional Review Act (CRA) Requires that before an agency rule becomes effective, it must be submitted to Congress for review Congress has 60 days to disapprove rule by 51% majority; President has to sign it If disapproved, a new rule cannot be issued in same substantive form without legislative authorization CRA definition of a rule is very broad: [R]ule means the whole or a part of an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or describing the organization, procedure, or practice requirements of an agency and includes the approval or prescription for the future of rates, wages, corporate or financial structures or reorganizations thereof, prices, facilities, appliances, services, or allowances therefor or of valuations, costs, or accounting, or practices bearing on any of the foregoing. Senator Toomey asked Government Accountability Office (GAO) to opine on whether Leveraged Lending Guidance is a Rule under the Congressional Review Act Since 1996, the GAO has provided at least 11 opinions addressing whether a particular agency action was a rule under the CRA 18
Leveraged Lending Guidance Change? Treasury s Report on Banks and Credit Unions In early June, Treasury issued its first report under the February Executive Order on Financial Regulation In the report, Treasury said that the Leveraged Lending Guidance was ambiguous In its recommendations, Treasury said: The Leveraged Lending Guidance should be re-opened for comment Definition of leveraged lending be refined to reduce ambiguity 19
Risk Retention: Legislation? Regulation? Litigation? Legislation CHOICE Act Would get rid of risk retention for all asset classes except residential mortgages Passed out of the House on a party-line vote Not expected to gain traction in the Senate Crapo-Brown efforts Regulation Heads of the Senate Banking Committee looking to do bipartisan FinReg fixes Not very likely that risk retention would make the cut Risk retention may be covered in the next Treasury report on asset management Litigation Lawsuit still pending on the applicability of risk retention to actively managed open market CLOs 20
So, What s the Outlook? The odds of FinReg refinements are higher than they have been in the past seven years Regulatory refinement is most likely to come about from efforts by the Administration and the regulators (once the new heads are in place) Because regulatory overhauls likely cannot be effected until there are new regulatory heads, do not look for significant changes until 2018 at the earliest 21
Appendix: Interest Deductibility & Loan Mutual Funds 22
Loan Mutual Funds: Revival And Impact of Liquidity Rules Loan Mutual Fund AUM and Market Share 30% 200 25% 20% 15% Loan Mutual Fund AUM ($Bils.) LMF Market Share 180 160 140 120 100 80 10% 60 5% 40 20 0% 0 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 AUM ($Bils) Dec-09 May-10 Oct-10 Mar-11 Aug-11 Jan-12 Jun-12 Nov-12 Apr-13 Sep-13 Feb-14 Jul-14 Dec-14 May-15 Oct-15 Mar-16 Aug-16 Jan-17 Loan mutual fund AUM returns to $150 billion context Open end fund liquidity risk management rules came out well But getting into compliance with rules is substantial work Source: TR-LPC, S&P/LSTA Leveraged Loan Index 23
Tax Reform and Interest Deductibility Companies with Lower ICR Hit Harder By Tax Reform 600% 500% Tradeoff leads to higher taxes Tradeoff leads to lower taxes House Republicans issued tax reform plan that removed deductibility of interest, but added immediate expensing of capex and lower rate 400% Trump plan was silent on interest deductibility % change in taxes paid 300% 200% 100% 0% Change in Cash Taxes - 20% Case Moody s analysis suggested The tradeoff between interest deductibility and capex expensing could lead to increase in taxes for a number of leveraged companies If a company s EBIT/Interest ratio was less than 2.33x (approx. 2/3 of their sample), then a company s tax payments might rise -100% 1.10x 1.25x 1.50x 1.75x 2.00x 2.25x 2.50x 2.75x 3.00x 3.25x 3.50x EBIT Interest Coverage Ratio (x:1) 3.75x 4.00x 4.25x 4.50x However, many moving pieces and differing opinions on whether tax reform is passed Source: Moody s 24