How the Guidance Indirectly Affects Community Banks

When banking regulators issued interagency guidance on leveraged lending in 2013, they were particularly concerned about the absence of meaningful covenants in loan agreements to address debt service coverage and maintenance of loan to values in collateral.

Regulators were also worried about a bubble in leveraged lending due to the Federal Reserve’s aggressive monetary policy and banks’ chase for yield, as well as the aggressive nature of capital structures and repayment assumptions for some transactions.

“Financial institutions should ensure they do not unnecessarily heighten risks by originating poorly underwritten loans,” the guidance stated. “Debt agreements have frequently included features that provided relatively limited lender protection including … the absence of meaningful maintenance covenants in loan agreements.”

Indirect Effect on Community Banks

The regulators were careful to point out that the guidance will not directly affect most community banks because they have limited involvement in leveraged lending. However, many community banks have begun to adopt some of the principles of leveraged lending in their small business loans.

One of these principles is the practice of expressing leverage as a multiple of EBITDA instead of in relation to tangible net worth, as community banks have traditionally done. According to the regulators, a leveraged loan is defined as a loan where total debt divided by EBITDA exceeds 4.0.

Here’s the problem with using EBITDA as an expression of leverage: EBITDA does not reflect cash that’s actually available for debt service. It only demonstrates a borrower’s ability to earn its debt service.

Using EBITDA to define leverage assumes that all cash flow will be dedicated to debt service. Of course, this isn’t the case in the real world. For example, cash is needed to support working capital requirements and fund capital expenditures, and owners make cash distributions to support their lifestyle. These things are critical to the long-term health and survival of the business.

Using TEV as Collateral

Another leveraged lending principle some community banks are adopting is relying on total enterprise value (TEV) as collateral when underwriting small business loans, especially loans to service businesses. This can be a dangerous precedent because TEV is usually comprised largely of goodwill.

If the business isn’t generating enough cash flow to service its debt, its value is going to decline. This, in turn, will jeopardize your secondary source of repayment — the entity itself. If your bank needs to liquidate the business to recoup the loan proceeds, there may not be anything left to liquidate because TEV is essentially worthless without cash flow.

Why Concerns Are Relevant

These concerns are especially relevant in the current economic environment and at the current stage of the business and economic cycle. The recovery, which has been one of the weakest in history, is now seven years old and talk is already starting about whether we might be headed for another recession sometime later this year.

With companies seeing fewer opportunities to grow organically by expanding their product lines or growing sales, many are replacing equity with debt. For example, they are borrowing money to make shareholder distributions, acquire other companies or even move operations overseas to lower taxes.

Therefore, community banks should use more discretion when loaning money to businesses with excessive leverage, which could be defined as a debt to tangible net worth ratio higher than 4:1. A slowing economy will hurt borrowers’ cash flows, which could adversely impact their ability to service debt. Rising interest rates will only exacerbate the problem.

In this environment, caution is the watchword. While the regulators’ leveraged lending guidance might not impact your community bank directly, there are some valuable takeaways in the guidance that could help you avoid problems down the road.

Got more questions about how the interagency leveraged lending guidelines may affect your bank? Give us a call.