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ECB published its 'Guidance on leveraged transactions' on 16 May 2017

ECB published its 'Guidance on leveraged transactions' on 16 May 2017

ECB published its 'Guidance on leveraged transactions' on 16 May 2017

02.08.2017 NL law

In the 'Guidance on leveraged transactions' (the "Guidance"), the European Central Bank (the "ECB") summarises key supervisory expectations concerning leveraged transactions, and the ongoing monitoring of both syndication risk and the fundamental quality of leveraged exposures. The Guidance will enter into force on 16 November 2017.

Background

After a period of low interest rates and an increased search for yield strategies, the ECB decided to survey a number of credit institutions to capture their involvement in leveraged finance activities. The outcome of the survey showed that since the crisis, the global leveraged finance markets have strongly recovered and that there is a strong competition which has resulted in very borrower-friendly conditions. The ECB also noted there are strong differences in individual credit institutions' approaches to defining, measuring and monitoring leveraged transactions. Considering, among other things, these developments and observations, the ECB decided that leveraged transactions should be supervised more closely.

Purpose

The key objectives of the Guidance are to develop a consistent definition of 'leveraged transactions' and to establish guidelines regarding risk management and reporting requirements applied to leveraged transactions.

Process

The ECB published a draft Guidance on 23 November 2016. After which, a public consultation started which ended with a public hearing in Frankfurt on 27 January 2017. The public consultation period gave market parties the opportunity to comment on the draft Guidance. The ECB published the final Guidance together with the 'Feedback Statement' on 16 May 2017. The Feedback Statement aims to provide an overview and assessment of the comments made on the draft guidance during the public consultation and gives some useful background as to certain choices made by the ECB.

Scope and enforcement (section 2 and 9 of the Guidance)

The Guidance applies to all significant credit institutions supervised by the ECB under Section 6(4) of the Single Supervisory Mechanism Regulation (Council Regulation (EU) No 1024/2013). Although the Guidance is non-binding, the ECB indicates that it will be enforced through, for example, the ongoing supervision of the credit institutions by the Joint Supervisory Teams (consisting of representatives of both the ECB and the local supervisor). The credit institutions are expected to implement the Guidance in their internal policies ultimately by 16 November 2017. The ECB notes that the implementation of the Guidance should be proportionate to the size and risk profile of the credit institution's leveraged transactions activities relative to its assets, earnings and capital. Furthermore, the credit institutions must prepare and submit an internal audit report to their Joint Supervisory Team ultimately by 16 November 2018. The report should set out how the expectations described in the Guidance have been implemented in the internal procedures of the credit institution.

Definition 'Leveraged Transactions' (section 3 of the Guidance)

The credit institutions should implement a single and overarching definition of leveraged transactions in order to enable its senior management to get a comprehensive overview of the credit institution's leveraged transactions. The definition should contain at least the following two conditions:

  1. All types of loan or credit exposure, where the borrower's post-financing level of leverage exceeds a Total Debt to EBITDA ratio of 4.0 times; and
  2. All types of loan or credit exposure, where the borrower is owned by one or more financial sponsors.

If a transaction meets at least one of these two conditions, it must be qualified as a 'leveraged transaction'. We note that terms such as 'Total Debt', EBITDA' and 'financial sponsor' are being clarified in the Guidance, but these will not be further discussed in this article. The ECB also listed certain transactions which do not fall within the scope of the definition, for example loans with natural persons, credit institutions, investments firms, public sector entities and financial sector entities as well as for example loans classified as specialised lending which comprises project finance, real estate, object financing and commodities financing.

Risk appetite and governance (section 4 of the Guidance)

According to this section, the credit institutions should define their appetite and strategy for leveraged transactions. Also, the credit institutions should implement a governance structure in their internal policies that meets at least the following three minimum requirements:

  1. Both senior management and risk management should have a consistent and integrated overview of all leveraged transactions;
  2. Prior review and approval of leveraged transactions risks by an independent risk function; and
  3. Dedicated procedures to avoid potential conflicts of interests and confidentiality requirements should be in place.

Syndication activities (section 5 of the Guidance)

In order to set up a limit framework regarding syndication activities, the credit institutions should define their appetite for syndicating leveraged transactions. The ECB also lists a number of aspects that the internal standards and monitoring functions of a credit institution should pay attention to when it comes to syndication activities. To give an example: credit institutions should identify 'hung transactions', i.e. transactions that were not syndicated within 90 days following the commitment date. They should also have a framework in place that describes how to deal with such transactions in terms of holding strategy, booking and accounting practices, regulatory classification and subsequent capital requirements calculation.

Policies and procedures for new deal approval, and monitoring and managing of longer-term leveraged transaction holdings (section 6 of the Guidance)

To ensure that transactions are aligned with the credit institutions' risk appetite, the credit institutions should implement a credit approval process for all leveraged transactions. The credit approval process should include a thorough due diligence by the originating function as well as a critical review by the independent risk function. A due diligence should take place not only in the event of a new transaction, but also in cases of a renewal, a refinancing or a material modification of an existing leveraged transaction. The Guidance contains a list of a few examples of minimum requirements of such due diligence. One of these requirements is that the credit institution should assess whether the borrower has an 'adequate repayment capacity'', which is defined in the Guidance as either the ability of the leveraged borrower to fully amortise senior secured debt or repay at least 50% of its Total Debt over a period of five to seven years.

Ongoing monitoring of the leveraged transactions should take place. The monitoring should include an update of the due diligence requirements, particularly of the repayment capacity mentioned above. In addition, credit institutions should define criteria to identify so-called 'unlikeliness to pay'-indicators.  

Reporting requirements and Management Information Systems (MIS) (section 8 of the Guidance)

The credit institutions should have so-called 'Management Information Systems' in place that can provide their senior management on a regular basis with comprehensive reports. The Guidance describes which aspects should at least be included in these reports, for example (i) key market trends; (ii) information on all its leveraged transactions across the various business units and geographies; as well as (iii) its positioning with regard to internal limits and the outcome of the stress scenarios that it should perform under section 5 and 6 of the Guidance.

Final remarks

To the extent not already incorporated in their internal policies, the credit institutions that fall within the scope of the Guidance will need to ensure that their internal policies comply with the Guidance ultimately by 16 November 2017. Through various manners the ECB will encourage compliance with the Guidance. Although the Guidance applies to leveraged transactions only, the ECB has stated that it encourages the credit institutions to apply the standards laid down in the Guidance to other types of transactions they are involved in.

A copy of the Guidance can be downloaded here:

https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.leveraged_transactions_guidance_201705.en.pdf?e922511e1579cb0f1b9f943b0a8960c6

A copy of the Feedback Statement can be downloaded here:

https://www.bankingsupervision.europa.eu/legalframework/publiccons/pdf/leveraged_transactions/leveraged_transactions_feedbackstatement.en.pdf

Team

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