8 MINS READ
Highlights
- Institutional leveraged loans are an important source of capital for small- and medium-sized companies. After the 2008 financial crisis, non‐banks became important sources of capital for these loans.
- The leveraged finance market has grown to almost three times since the last financial crisis.
- We explore the economic significance of leveraged lending and the constraints of managing and monitoring exposures.
In this article
In this articleinpage
Abstract
The market exposure for institutional leveraged loans has grown meaningfully in recent years, with issuance activity largely concentrated in the US than the European Union.
Changes to banking regulations have incentivized the origination, distribution, and sales of broadly syndicated loans (BSLs), which allow non-banks to hold and trade leveraged loans.
Institutional lenders, including middle-market asset managers, pension, and hedge funds have increased their exposure to BSLs. After the 2008 financial crisis, new regulations, such as Dodd‐Frank and Basel III, required banks to increase their base capital, materially tighten underwriting standards, and enhance reporting levels. As a result, non‐banks became increasingly important sources of capital for leveraged loans, while banks continued to follow the underwriting and distribution model. This helped banks to generate demand for credit for middle-market companies by managing risk and capital allocations.
We examine the leveraged lending asset class and identify the constraints of managing and monitoring exposures. We also explore the economic significance of these loans, which provide growth capital to middle-market companies.
Bank and non-bank financing exposure to leveraged lending
There is no standard description for institutional leveraged loans; however, they are generally referred to as loans issued to middle-market companies that are highly indebted or have a low credit rating.
It’s an important source of capital for small- and medium-sized companies. For investment-grade companies with a credit rating below BBB- or Baa3 or for borrowers with post-funding leverage significantly exceeding the industry average, a leveraged loan can meet their demand for growth and general corporate purposes. Middle-market corporates can utilize these loans for refinancing an existing loan, dividend recapitalization, or funding a leveraged buyout and portfolio acquisitions. More than 65% of companies in the US hold below investment grade ratings, positioning leveraged loans as a critical source of financing and growth for small and medium-sized companies. The leveraged finance market has grown to almost three times since the last financial crisis. For relative comparison, the leveraged loans market size (excluding bonds and securities in the leveraged finance market) is equivalent to the total credit card debt and is more than the auto loan outstanding in the US.
Leveraged loan transactions are placed at the top of the capital structure. They are generally secured with a first lien on most of the assets of the obligor and first in line for debt repayment. Senior secured leveraged loans consist of multiple components and tranches, including a revolving credit facility and term loans.
Besides, large banks, several non-bank lenders, and institutional investors are also exposed to leveraged loans. These players include investment funds, insurance companies, broker dealers, asset managers, and holding companies. Due to changes in regulations and banks’ risk-averse approach to holding leveraged loans on their balance sheets, non‐bank lenders play a critical role in closing the funding gap for small and medium‐sized companies and growing investment grade credit portfolios. Several investments and non-investment grade fund corporations have substituted corporate loans products issued by banks with leveraged loans.
Limitations of leveraged loans
Banks face operational, financial, and regulatory challenges to effectively address internal credit policy guidelines and increased regulatory examination requirements for lending exposures.
Given the high balance sheet exposure and complex credit and regulatory dynamics, banks require rigorous and regular monitoring and surveillance of assets and portfolios to manage and retain them. Regulators and international financial institutions have expressed concerns about the credit quality, liquidity, growth, and exposure of leveraged loans in the overall lending market. Introducing this asset class presents the following challenges:
- Lack of standard portfolios and collateral surveillance mechanisms among banks to achieve real savings and meet various regulatory deliverables.
- Variation in the intensity and effectiveness of enhanced surveillance and adherence to regulatory guidelines across banks, especially systemically important financial institution (SIFI) banks. A regulatory environment analysis suggests an alternative portfolio surveillance mechanism to avoid major risk monitoring issues – both at asset, facility, and aggregated global book exposure levels.
- The need to remain updated on internal and regulatory asset and portfolio-level surveillance. Several regulatory exams highlight instances of inadequate loan reviews, the granularity of concentration risks, and the quality required to provide an independent assessment of leveraged credit portfolios.
- For new loan syndication opportunities, banks do not have a single source of truth and technology. This makes the information of syndicated parties vulnerable, which in turn duplicates the assessment efforts of current exposure and may affect the risk grades for new loans.
- Less stringent lender protections through looser covenants (covenant-lite loans or similar) and general documentation weaknesses, providing increased flexibility to borrowers.
Besides, the absence of a single market utility to collect, collate, and process common obligor and investor data for credit management and surveillance remains a challenge.
Optimistic growth for middle-market companies
Despite significant changes in lending markets and systematic risks associated with leveraged loans and lender surveillance constraints, lending practices have evolved to address new risky lending to promote growth for middle-market companies.
Institutional leveraged loans have played a critical role in meeting the capital requirements of middle-market companies and are expected to remain a long-lasting trend. Both banks and non-bank firms continue to leverage this asset class for better margins and accelerated growth.
Portfolio governance persists, even as broadly syndicated lending has become more complex since the last economic crisis. However, regulatory requirements have tightened, and investor security has become paramount over time, forcing banks and non-banks to improve resiliency in portfolio management.
- Lenders have started exploring point solutions to strengthen risk governance. For example, banks and non-banks can collect and aggregate data from micro data marts to meet credit regulatory compliance.
- Banks are leveraging niche domain-led technology partnerships to digitalize and strengthen existing data. They then reuse and auto-populate this data for credit appraisals, surveillance, and portfolio monitoring.
- Banks have realized that the monitoring process rigor, along with software and technology tools, help them examine portfolios at a granular level expected by regulators. Understanding the asset class, warehouse lending structure, and sponsors’ liquidity arrangement and credit terms as to how these loans should be serviced, remain critical due to the complexity and large exposure of leveraged loans.
- Unlike legacy banks that still employ manual methods for borrower information gathering and behavioral analysis to monitor credit, non-traditional lenders are turning to near real-time data, artificial intelligence (AI), and machine learning (ML) tools. These technologies monitor and assess risks with the objective to glean meaningful insights on a borrower’s behavior and liquidity position.
- Despite the additional credit risk, leveraged loans are senior secured loans in a company’s capital structure and are the first to be repaid in case of a default. Besides, banks have been maintaining higher levels of capital and liquidity after the 2008 financial crisis to remain resilient in managing exposure.
When compared to traditional syndicated loans, leveraged loans are unique, as there are larger and more diverse types of lenders. To effectively monitor these diverse set of complex exposures, banks require pooling a variety of quantitative and qualitative data to generate meaningful responses for treasury, credit officers, and regulators. For example, they compare and measure borrowers across a variety of credit metrics, including leverage, repayment capacity, credit quality, and concentration limits. Besides, bankers monitor the restrictions placed in credit agreements, which forbid borrowers from performing certain activities. To execute this effectively, bankers require expertise in the underlying asset class and need to make manual judgement-based interpretations.
Technology-led automation strengthens the overall exposure monitoring functions. Financial statements can automatically flow into banks’ financial spreading tool without any manual data entry. For example, banks use an application program interface (API) to pull information directly from the credit agreements or borrowers’ accounting data software. They also customize optical character recognition (OCR) technology to extract relevant financial information from financial reports and scanned annexure documents. ML further refines the interpretation and comparisons to reduce manual intervention, allowing analysts to focus on making credit decisions, which enhances efficiency.
The way forward
With banks, non-bank lenders, and investors continually looking for higher yields, the leveraged loan market is expected to grow to meet the demands of both investors and middle-market financing.
The digital disruption in the leveraged finance sector has been relatively slow but financing companies have made progress; for instance, banks are using advanced data analytics for regulatory reporting and compliance. Credit assessment, surveillance, and execution comprise several qualitative factors that are difficult to incorporate straight into a digital model. However, banks and asset managers are exploring data solutions to leverage existing available data and niche micro-services and cloud-based solutions to meet the objectives of effective credit surveillance and monitoring.
Banks are also exploring a consortium to share common sponsors and asset-level service data for syndicated leveraged loans. However, it is too early to predict how this will evolve into a common data exchange due to legal, material non-public information, and commercial vulnerabilities.
While leveraged lending continues to be a growing market providing strong yields, the regulatory controls, consistent data, and portfolio surveillance rigor to manage this asset class remains critical. In a nutshell, leveraged loan products provide an excellent opportunity for banks, non-bank lenders, and investors to collaborate and provide growth capital to small- and middle-market companies.
