ECB Guidance on leveraged transactions
1 June 2017
Regulatory News Alert
Following a public consultation, on 16 May 2017 the European Central Bank published its final guidance on leveraged transactions to enhance a higher scrutiny level of leveraged transactions for significant credit institutions. This guidance is the equivalent of the US guidance on leveraged lending, published in March 2013.
The guidance is applicable to all significant institutions supervised by the ECB, and its requirements will be applied in a proportionate manner that is consistent with the size and the risk profile of institutions’ leveraged transactions.
This guidance aims to (1) facilitate the identification of leveraged transactions and (2) outline expectations regarding the risk appetite and approval and monitoring process for leveraged transactions.
Identification of leveraged transactions
Credit institutions should set up a single and harmonized definition of leveraged transaction to provide senior management with a comprehensive overview of the institution’s leveraged activities.
According to the ECB, any transaction meeting at least one of the conditions below should qualify as a leveraged transaction:
- The borrower’s post-financing level of leverage exceeds a Total Debt to EBITDA ratio of 4.0 times
- The borrower is owned by one or more financial sponsors
Notwithstanding the conditions described above, the ECB has specified a number of transactions that are not expected to be considered as a leveraged transaction.
Risk appetite and governance
Credit institutions should define their risk appetite and strategy and have a sound governance structure in place for leveraged transactions. The management body establishes, reviews, and adopts the leveraged transaction’s strategy at least on an annual basis. The ECB considers the following elements to be minimum requirements:
- Senior management and risk management should have a consistent and integrated view of all leveraged transactions
- All leveraged transactions that imply credit, syndication, or underwriting risks should be preceded by a review and approval of an independent risk function
- Procedures should in place to avoid conflicts of interest and leakage of confidential information
In particular, credit institutions should define a strategy for syndicating leveraged transactions. The guidance lists a number of internal standards that should be taken into consideration.
As an example, the ECB made it clear that high leverage levels, defined as the ratio of Total Debt to EBITDA ratio exceeding 6.0 times at deal inception, should remain exceptional.
Credit approval and ongoing monitoring
A credit approval process should be set up for all transactions to align the leveraged transaction level with the institution’s risk appetite. For this purpose, an in-depth due diligence should be conducted for any new transaction, renewal, or refinancing of an existing leveraged transaction. The independent risk function in charge of performing the due diligence should consider the following elements (non-exhaustive list):
- An in-depth assessment of the borrower (Cash-flow generation)
- Stress test on the business plan and projections provided by the borrower
- An enterprise valuation of the borrower
- An assessment of the structure of the transaction and related term sheets
Credit institutions should also perform an ongoing monitoring of leveraged transactions. In this regard, the ECB makes clear that credit institutions are required to have clearly defined criteria to identify indicators of a borrower’s “unlikeliness to pay.” In addition, an impairment test has to be conducted in a number of situations defined by the ECB.
Entry into force
The ECB guidance will come into force in November 2017.
The review of leveraged transactions and of the compliance with this guidance should be part of the internal audit cycle and tested at least every three years.
Significant credit institutions will be required to draw up and submit to the joint supervisory team an internal audit report in November 2018, detailing how the expectations expressed in this guidance have been implemented in their procedures.
In its feedback statement, the ECB indicated that the guidance is not binding. However, its enforcement will be ensured through the ongoing supervision of credit institutions by Joint Supervisory Teams (JSTs), as well as dedicated on-site inspections. It will also be taken into account in the Supervisory Review and Evaluation Process (SREP).