January 30, 2019 - The past week has brought two notable research pieces on the state of credit. First, last Friday, saw the release of the Shared National Credit (SNC) Review, which discusses risks in the syndicated loan market. Second, this week, Covenant Review compared the credit stats of the largest LBOs of 2007, 2017 and 2018. We dissect both reports below.

We begin with the SNC Review, which we (and LPC) read with great interest. Our takeaways were three-fold.  First, risk was down in the SNC portfolio. Second, nevertheless, the SNC warned about leveraged lending risks. Third, SNC acknowledged that banks have shown (some) improvement in their risk management practices. We take these in order.

The numbers clearly show that risk has declined in the $4.4 trillion SNC portfolio (which approximates to syndicated loans over $100 million). The volume of loans risk-rated Special Mention (i.e., with potential weaknesses that warrant review) fell 14%; the volume of classified loans (those rated below Special Mention) dropped by 36%. While this suggests improvements in the quality of the loan portfolio (including leveraged loans), SNC observes that much of this was driven by an improvement in the oil & gas sector.

Duly noted. But perhaps more interesting was the messaging around leveraged lending. After the GAO opined in 2017 that Leveraged Lending Guidance was a rule for the purposes of the Congressional Review Act, some commentators suggested that bank supervision of leveraged lending was dead. They were wrong. As was discussed by the Fed at the LSTA Annual Conference, and reiterated here, the Agencies still are providing direction on leveraged lending.  Specifically, the SNC commented on increased risk layering in loans, focusing on weaker transactions structures, greater reliance on revenue growth or cost savings to support repayment, and borrowers exhibiting greater control over lending relationships. The SNC then went on to clearly state what underwriting banks should be doing, including, i) understanding and supporting borrowers’ ability to achieve revenue growth or cost savings, ii) incorporating potential incremental facility usage into expectations, and iii) accounting for changing market dynamics or recovery rates in expectations.

The good – and generally ignored – news? Agent bank risk management and underwriting practices have improved (in some respects) since 2013. Banks are better equipped to assess repayment capacity and enterprise valuation and have developed risk management processes that better align with safety and soundness principles.

The SNC’s comments on leveraged lending bring us to the burning question of our time: How do today’s loans compare to those of 2007? Fortunately, Covenant Review digs into this, comparing the biggest LBOs of today versus yesteryear.  So how do they fare?

First the current generation of jumbo deals are far less jumbo than the 2007 cohort. The average purchase price of 2018’s 12 largest LBOs was a mere $3.7 billion, as opposed to $13.7 billion in 2007. Moreover, on an adjusted basis, total leverage today appears much lower today (6.09x) than in 2007 (7.93x). However, as we know, adjustments have increased. Average adjustments were 13% of EBITDA in 2007; now they are around 28%. Using unadjusted EBITDA brings the total leverage numbers closer (9.3x in 2007 vs. 8.67x in 2018).

Another notable change since 2007 is the decline of the bond market. With loans and second liens increasingly replacing bonds, senior debt multiples have climbed. As a result, on an adjusted basis, first lien leverage in 2007 (4.84) and 2018 (4.41) are fairly similar. Take the adjustments out and 2018 first lien leverage (6.29x) is above 2007 levels (5.68x).

That said, EBITDA adjustments are not the only changes between 2007 and 2018 documents. There is more optionality in loan agreements, which permits collateral leakage and additional debt incurrence. But quantification may lead to more informed decision-making. And that is why we were happy to see a new tool that quantifies the aforementioned loan document qualities.