In February, the Fed clarified a point in the guidelines that says borrowers should be able to repay senior debt within five to seven years. The Fed said it would be concerned if the bulk of a repayment happens toward the end of the five- to seven-year period.
But this clarified point isn’t compatible with the add-on acquisition strategies of some PE firms. The Fed generally starts flagging transactions that are at 6x leverage. As far as middle-market deals go, this affects only a small percentage of transactions in the upper middle market, and fewer deals lower down in the market.
“Since the middle market is mostly below those levels and multiples of senior bank financing, the amortization requirements of the regulatory bodies are not as relevant,” says Ted Koenig, CEO of Monroe Capital. Buyers that want a loan that would put more than 6x debt on a business are likely going to a non-bank lender, because they aren’t regulated by the Fed.
Paying a loan back early doesn’t mesh with the strategies of many PE firms, who like to have access to cash to make add-on acquisitions. “Private equity firms are acquisitive in nature they want the greatest amount of flexibility when it comes to making their next acquisition,” says Jeff Kilrea (pictured), co-head of CIT Sponsor Finance, a unit of CIT Group Inc. (NYSE: CIT). “When a private equity firm is paying 12x or 14x, they are looking to lever the business as much as possible,” Kilrea says. That leverage would generally be brought down as quickly as possible.
The guidelines though, would generally stop banks from lending on those deals to avoid having “criticized asset” on their balance sheets. Too many criticized assets can affect a bank’s rating with the Office of the Comptroller of the Currency (OCC) and lead to a rating downgrade. This opens up even more of an opportunity for non-bank lenders as they continue to occupy the lending space banks have vacated.