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Manufacturing and Wholesale Distribution: New Lending Rules Could Slow Private Equity Deals


New federal guidelines aimed at ending risky lending practices could make it harder for private equity (PE) firms to land highly leveraged bank loans. The potential impact on the PE industry: less deal flow and lower valuations for leveraged buyout deals.

U.S. market regulators, including the Federal Reserve Board, the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency (OCC), are increasingly worried that prudent underwriting practices have eroded since the end of the global economic recession. In response, the regulators want to restrict bank loans with higher leverage levels and uncertain repayment prospects. Their goal is to avoid a repeat of the market meltdown brought on by years of reckless mortgage underwriting.

“As regulators, we certainly hope to change bad practices and remove the extraordinary froth that is experienced at the peak of a credit cycle,” Martin Pfinsgraff, a senior regulator at the OCC, recently told The Wall Street Journal. “The impact on private equity, a significant driver of what we see as risky practices, is an intended consequence of our actions.”

The new federal guidelines, which generally apply to leveraged loans of $20 million or more, went into effect last May. Under the guidelines, updated for the first time since 2001, leverage levels above six times debt-to-EBITDA after asset sales are now classified as “criticized loans.” In 2013 the percentage of U.S. leveraged buyouts with a debt-to- EBITDA ratio above six times was at 27%, the highest level since 2007, when it reached 52%, according to S&P Capital IQ LCD.

With more than 1,400 deals completed in the manufacturing and wholesale distribution space in 2013, the new federal guidelines could cause a significant contraction in M&A and capital raising activity moving forward. According to Pitchbook, 88 of the 1,400 completed deals were U.S. leveraged buyouts that would be scrutinized under the new federal guidelines – using the ratio that 27% of these deals had a debt-to-EBITDA ratio above six times, it is likely that 24 of the 88 deals would not have closed.

Banks that participate in deals that regulators consider too risky could face fines or other enforcement actions. The real concern for private equity—and for company owners looking to sell their businesses to private equity—is that these new guidelines could curtail the size and number of deals that get done.

Imagine, for example, a mid-market widget manufacturer in Cleveland that is poised for growth and wants a PE partner to take the business to the next level. The widget maker and PE firm agree on a sale price where the PE firm would finance the acquisition through a combination of debt and equity. In this case, the PE firm would need to obtain debt financing at a leverage ratio of six times debt to EBITDA. In the past, most banks would be happy to make that loan and charge the associated fees. Now, however, banks might hesitate to proceed with a transaction at those leverage levels for fear of angering regulators.

Clearly, the federal guidelines have the potential to hinder growth in the middle market. And those leveraged buyouts that do get done will likely come at reduced valuations. Until now debt capital was freely available and relatively cheap, so PE firms could pay more for deals. If a PE firm put $10 million into a deal and took $40 million in debt, it could pay a total of $50 million for a company. But when a PE firm can only get $20 million in debt, it cannot pay nearly as much for that same company, which severely restricts valuations.

In some cases deals will be squashed altogether. The Wall Street Journal recently reported that Bank of America, Citigroup, and JPMorgan Chase are among lenders that have in recent months decided against financing some corporate takeovers partly out of concern that the deals will run afoul of the new federal guidelines. Citigroup decided, in part because of the new guidelines, not to finance KKR’s $1.6 billion leveraged buyout of commercial landscaper Brickman Group, according to published reports.

The new regulations are not bad news for everyone. As regulated banks grapple with tighter lending standards, their non-regulated competitors can rush in to fill the vacuum. These lenders—which include broker-dealers like Jefferies Group, the credit arms of megabuyout firms like KKR and Blackstone Group, and finance companies, hedge funds and insurance companies—are not regulated as banks are and do not face the same strict requirements.

Nonbank lenders accounted for 83% of total middle-market volume last year, up from 77% in 2012 and 70.6% in 2011, according to S&P Capital IQ LCD. And, thanks to the new federal guidelines, their share of the pie seems likely to grow, as regulated banks find it harder to compete and private equity firms expand the number of lenders they approach.

Underwriters are still examining the new guidelines and determining which deals will pass the sniff test. For instance, will the feds deem a loan “criticized” if it fails one, two or all of the updated guidelines? And what number of criticized loans can a bank have on its balance sheet before running afoul of regulators? Amid this uncertainty, banks are playing it safe and avoiding deals that could land them in hot water.

For mid-market manufacturing companies that are thinking of partnering with a private equity firm, the new federal guidelines mean that, if they want to go to market and get the very best price for their business, they should take actions  to sell in the next six months. Until the new guidelines are fully enforced, capital will likely remain available and debt will remain cheap. But when that changes and credit suddenly tightens, valuations could plummet.

What Does CohnReznick Think?
If regulated banks can no longer lend to companies that are at or above the six times debt-to-EBITDA threshold, a significant source of debt capital in private equity transactions could quickly dry up. The market is driven by the availability of inexpensive debt capital—but if a major source of debt capital is suddenly removed from the market, the ability of private equity firms to close deals, as well as the ability of sellers to get the highest price for their companies, could be negatively impacted. At the same time, nonbank lenders could gain a competitive advantage, as they are not regulated and the new guidelines do not apply to them.


For more information, please contact Jeremy Swan, Principal, Private Equity and Venture Capital Industry Practice, at 646-625-5716, or Alan Wolfson, Partner and Manufacturing and Wholesale Distribution Industry Practice Leader, at 646-254-7416.

To learn more about CohnReznick’s Manufacturing and Wholesale Distribution Industry Practice, visit our webpage.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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