REGULATION WILL INCREASE LBO FINANCING COSTS

Hedge funds and institutional investors set to become bigger holders of leveraged loans, claims Close Brothers

8 February 2008, London – The implementation of Basel II across the EU at the start of 2008 will increase the cost of debt for private equity investors and will ultimately lead to institutions and hedge funds holding larger proportions of Leveraged Buy-Out (LBO) debt, reveals Close Brothers Corporate Finance (“Close Brothers”).

Private equity-owned company debt is largely sub-investment grade, having a low credit rating due to its highly leveraged nature.  As a result, Basel II should lead to an increase in the cost of debt at these companies.

Close Brothers believes the cost of debt will rise as commercial banks are now obliged to set aside higher levels of capital when lending to creditors with lower credit ratings.  The standard approach under Basel II means banks lending to companies with a credit rating of BB- and below (of which most private equity portfolio companies are ranked) are faced with a 50% increase in capital requirement under the new Basel II approach. 

Commenting on the impact of Basel II, Simon Tilley, Head of the Close Brothers European Financial Sponsors Group said:

“If lending to highly geared businesses under Basel II is going to require a 50% increase in the level of capital to be reserved by banks then this should, assuming rational behaviour, translate into at least a similar increase in the cost of borrowing.  For more challenged or more highly leveraged creditors the cost increase will be greater.”

Conversely, Basel II also means that banks lending to companies with higher credit ratings (AAA to A-) will require them to hold up to 80% less in core tier 1 and 2 capital.  So the cost of debt for FTSE 100 companies, insurance companies and other highly rated corporates should come down significantly. 

Simon Tilley comments:

“The introduction of Basel II at the same time as massive sub-prime losses, a global credit crunch and increasing concerns around consumer fragility, will undoubtedly make banks choosier about which deals and companies they support.  I don’t expect this to be a short-term phenomenon; it’s the way the market is moving.”

Pricing in the leverage finance market has, to date, followed a strict convention.  The massive influx of institutional liquidity between 2005 and mid-2007 enabled borrowers to negotiate reductions in interest costs.  Since mid-2007 this has reversed, with pricing now much higher than the long-term historical average. 

Simon Tilley continues:

“The new regulations are likely to encourage banks to prioritise borrower relationships on a total returns basis.  At times like this the value of relationship banking becomes most apparent. That said private equity investors are also shopping around to identify pockets of liquidity and exploit anomalies in the debt markets in an effort to secure financing packages that differentiate their bids.”

Hedge funds and institutional investors not impacted by Basel II (as they are not deposit-takers) are likely to become the holders of choice for sub-investment grade debt.  The market was moving this way until liquidity dried up in mid-2007, since when the market has reverted to being bank-driven, with deals being structured much more conservatively and debt priced at a premium.

Although the banking industry’s “origination and distribution” model has recently suffered as a result of the retrenchment of hedge funds and other institutional investors, lending banks are likely to look to distribute sub-investment grade debt to institutions that are not regulated by Basel II, as soon as market conditions permit. 

“Basel II will impact the economics of LBO lending which will encourage greater levels of hedge fund and institutional involvement.  This at a time when we have seen unprecedented levels of liquidity withdrawn from this class of investor.  Successful deal making in the current environment is going to require a more sophisticated approach to capital raisings with borrowers taking the lead.”

ENDS

Notes to editors:

1. In 1988, the Basel 1 accord introduced the idea that each type of asset held by a bank has different risk weightings. Basel 2 is taking this idea further and introduces different risk weighting within asset classes.

2. Basel 2 imposes on banks the need to set aside greater tier 1 capital for riskier, or lower rated, creditors. Conversely, less capital needs to be set aside for more highly rated companies.

3. Basel 1 applied a 100% risk weighting to all corporate exposures, whereas the Basel 2 standard approach introduces the following grading:

4. The above table shows there is a substantial reduction in risk weightings for top end of investment grade companies (AAA to A-) – from 50% to 80%

5. The risk ratings for cross-over loans, from BBB+ to BB-, are not changing under Basel 2

6. However creditors with a credit rating of BB- or worse face a 50% increase in risk weighting

7. The Basel 2 regulations allow for sophisticated regulated banks to adopt their own internal risk assessment, returns and capital management models, rather than being required to adopt the standard approach.  This will result in many large banks implementing their own internally-formulated capital adequacy and risk-adjusted returns criteria

8. Assessing the likely impact of Basel 2, the third Quantitative Impact Study has shown an overall reduction in credit risk related capital requirements for banks - a 14% reduction for corporate exposures was observed