The two private-equity firms said in recent filings that regulatory guidelines may limit the amount of loans they can access to finance buyouts. That might force them to increase the amount of their own money used for purchases, potentially hurting returns.
The Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency announced the recommendations as high-risk loan volume reached record levels last year amid weakening underwriting practices. While firms typically disclose all material risks to their business in regulatory disclosures, New York-based KKR and Apollo’s filings may mark the first time the potential effects of the leveraged-lending guidance have been included in their annual reports.
The guidelines may “disproportionately affect the private-equity firms because the amount of leverage they can take on has a direct effect on their equity returns,” Richard Farley, a partner in the leveraged finance group in New York at law firm Paul Hastings LLP, said in a telephone interview.
Regulators are seeking to set minimum standards in a market that saw its largest year of issuance in 2013 with $353.4 billion of new loans arranged, according to data compiled by Bloomberg. Issuance of covenant-light loans, which lack typical lender protections, rose to $311.4 billion in 2013 from $105.7 billion in 2012, the data show.
Private-equity firms use loans to back their leveraged buyouts, as well as invest in the debt directly through their credit units.
KKR, in its annual filing on Feb. 24, said regulatory actions aren’t designed to protect holders of “interests” in its business and “often serve to limit our activities.”
“Federal bank regulatory agencies have issued leveraged-lending guidance covering transactions characterized by a degree of financial leverage,” the firm wrote in the filing. “To the extent that such guidance limits the amount or cost of financing we are able to obtain for our transactions, the returns on our investments may suffer.”
Kristi Huller, a KKR spokeswoman, declined to comment.
Apollo brought the matter to the attention of its investors in its annual regulatory filing on March 3, using similar wording.
Leon Black, Apollo’s founder, criticized regulators’ proposed clampdown on debt levels in leveraged buyouts during a February conference.
“To have a blanket number like that is micromanaging too much from a regulatory point of view,” Black said Feb. 28 at Columbia Business School’s Private Equity and Venture Capital Conference in New York. “Different industries have different growth rates” and other factors.
Charles Zehren, a spokesman for Apollo at Rubenstein Associates, declined to comment.
“The OCC has issued some guidance, but it hasn’t issued a rule,” David Rubenstein, co-founder of the Carlyle Group LP (CG:US), said March 26 at the Thomson Reuters Third Annual PartnerConnect East conference. “The banks are very careful about what they do and I think they might have some deals that they might not do that they would have otherwise done. But generally there are a lot of banks out there and there’s a lot of non-banks that are also available to provide lending, so it’s not a big problem for us.”
No similar warnings appeared to be contained in the 2013 annual filings by Carlyle and Blackstone Group LP. (BX:US) Randall Whitestone, a Carlyle spokesman, declined to comment. Peter Rose, a Blackstone spokesman, couldn’t immediately comment.
The Fed, the FDIC and the OCC said in March 2013 that a leverage level in excess of six times total debt to earnings before interest, taxes, depreciation and amortization “raises concerns for most industries.”
The absence of “meaningful” covenants is a sign that “prudent underwriting practices have deteriorated,” the regulators said in a March 21 statement accompanying the release of the guidelines. The advisory also said underwriting standards should consider a borrower’s ability to repay and “delever to a sustainable level within a reasonable period.”
The regulators followed up with letters that said banks should establish policies that deter the origination of loans classified as having a deficiency that might lead to a loss.
Leveraged loans are rated below BBB- by Standard & Poor’s and less than Baa3 at Moody’s Investors Service. There have been $73.5 billion of new loans arranged in the U.S. this year, according to Bloomberg data. Collateralized loan obligations are a type of collateralized debt obligation that pool high-yield, high-risk loans and slice them into securities of varying risk and return.
It’s not just private-equity firms that have alerted investors about the guidelines.
KCAP Financial Inc. (KCAP:US), a business development company, which includes a middle-market investment business, as well as the asset-management groups Katonah Debt Advisors LLC and Trimaran Advisors LLC, warned about the guidelines in its annual filing on March 13. It said the leveraged-lending guidance may affect the ways in which banks originate loans, in which it invests.
Denise Rodriguez, investor relations at KCAP, declined to comment.
BDCs, which are typically publicly registered companies, may invest in, and provide loans to, smaller or middle-market companies.
Art Penn, chief executive officer of PennantPark Investment Corp. (PNNT:US), a BDC, was asked in a Feb. 6 earnings call about how the guidance would affect the firm and its lending practices, according to a transcript of the call.
“There is a large chatter about the regulations and how they’re impacting banks,” Penn, who is based in New York, said on the call. “As the year progresses through 2014, we’ll see if it becomes material and we’ll see if it’s helpful to middle-market lenders like BDCs.”
Loans in the middle market are typically “less leveraged and usually” come with more covenants, Penn said in a telephone interview. These loans are often “priced more rationally” than largely syndicated loans sold to CLOs and mutual funds.
The broadly syndicated market is being driven by the influx of cash from these investors, which are forced to purchase assets, and the increased investor appetite allows deals to be marketed more aggressively, with higher leverage and fewer covenants, he said.
“With regulation, with Dodd-Frank, with Basel III, we hope that the opportunity will be there for BDCs and other vehicles that are there, to fill the gap for smaller and mid-size businesses,” he said in the interview.
Penn concluded his answer on the earnings call with: “Stay tuned.”
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