Why Valuations Matter to Lenders

On March 22, 2013, bank regulators consisting of the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (collectively, the “agencies”) jointly issued final guidance[1] on leveraged lending. Ostensibly, the goal of the guidance was “to assist financial institutions in providing leveraged lending to creditworthy borrowers in a safe-and-sound manner.” A less anodyne-sounding interpretation of the regulators’ intention: to force banks to be more conservative about making leveraged loans in an attempt to avoid a repeat of the 2008 financial crisis. Two-and-a-half years after the compliance date of May 21, 2013, industry insiders are starting to understand how the agencies will enforce the new guidance.

Interestingly, while the guidance has impacted nearly the entire United States banking system, including national banks, federal savings associations, state nonmember banks, state member banks, bank holding companies, and U.S. branches and agencies of foreign banking organizations, it provides no clear “bright line” definition of leveraged lending. Instead, the guidance shirks, stating that numerous definitions of leveraged lending exist throughout the financial services industry and commonly contain some combination of the following:

• Proceeds used for buyouts, acquisitions, or capital distributions.
• Transactions where the borrower’s Total Debt divided by EBITDA or Senior Debt divided by EBITDA exceed 4.0x EBITDA or 3.0x EBITDA, respectively, or other defined levels appropriate to the industry or sector.
• A borrower recognized in the debt markets as a highly leveraged firm, which is characterized by a high debt-to-net-worth ratio.
  Transactions where the borrower’s post-financing leverage, as measured by its leverage ratios (for example, debt-to-assets, debt-to-net-worth, debt-to-cash flow, or other similar standards common to particular industries or sectors), significantly exceeds industry norms or historical levels.

Per the guidance, the onus is on the financial institution engaging in leveraged lending to define the term. However, it must be defined “within the institution’s policies and procedures in a manner sufficiently detailed to ensure consistent application across all business lines. A financial institution’s definition should describe clearly the purposes and financial characteristics common to these transactions, and should cover risk to the institution from both direct exposure and indirect exposure via limited recourse financing secured by leveraged loans, or financing extended to financial intermediaries (such as conduits and special purpose entities (SPEs)) that hold leveraged loans.”

Leveraged lenders should understand that regulators are looking for what they call “examiner red flags,” which will cause more costly probes into the unlucky lender’s management systems and loan portfolio. While in and of themselves relatively innocuous, red flags can eventually lead to “non-pass” ratings at a bank and result in penalties from regulators.

Compliance with the prescribed practices related to underwriting standards and valuation standards seem to be of special concern for the regulators. For example, red flags are raised when examiners see cash flow projections as “overly optimistic” or unrealistic, and when projections aren’t stress tested for variables like interest-rate shocks or debt covenant breaches. Regulators also become concerned when the majority of debt repayment is projected to occur late in a five-to-seven year time frame.

Houlihan Capital has learned from sources in the banking industry that the determination of enterprise values of borrowing firms has also drawn more intense scrutiny of late. Bank regulators recognize that financial institutions often rely on enterprise value when evaluating the feasibility of a loan request, and now they are enforcing the guidance which reads “enterprise valuations should be performed by qualified persons independent of an institution’s origination function” [emphasis added]. This can be an onerous requirement, especially for regional banks that lack in-house resources to understand, document, and support all the underlying assumptions necessary for enterprise-value estimates.

The most expedient solution for these firms may be to outsource certain valuation functions, specifically those in connection with enterprise values, to independent experts. Houlihan Capital has worked with many financial institutions to meet their valuation needs. Houlihan Capital is a leading, solutions‐driven valuation, financial advisory and boutique investment banking firm committed to delivering superior client value and thought leadership in an ever‐changing landscape. The firm has extensive experience in providing fairness and solvency opinions, and objective, independent and defensible opinions of value that meet accounting and regulatory requirements. Our clients include some of the largest asset managers around the world, and private equity funds, hedge fund advisors, fund administrators, and other asset management firms benefit from Houlihan Capital’s comprehensive valuation and financial advisory services. Houlihan Capital is SOC-compliant, a Financial Industry Regulatory Authority (FINRA) and SIPC member, and committed to the highest levels of professional ethics and standards.

For more information on independent third party valuation services, please visit www.houlihancapital.com or contact Paul Clark at 312‐450‐8656.

[1] Portions of the final guidance are reproduced verbatim throughout this article as appropriate.