M&A Valuations To Fall?: New Rules Likely To Curtail Bank Lending
In March 2013, U.S. banking regulators issued new guidance designed to curb increasingly aggressive lending by both banks and finance companies. The new guidance is intended to provide a "safer" financial landscape and reduce the risk of a financial crisis like the one that occurred in 2008.
Background. Regulators have been under fire from Congress and the current administration for failing to address what is believed to be overly aggressive lending preceding the financial crisis. Historically, the Fed could use its open market policy to raise interest rates as a mechanism to manage lending risk. Theoretically, weaker credits and riskier transactions would be unable to support the higher interest costs, and thereby reduced lending risk. Today, with limited ability to raise interest rates in the current fragile economic recovery, the Fed has focused on influencing leverage as a way of managing risk. Financial system stability is the intended benefit, as high-risk lending is slowed or stopped, thereby avoiding (or at least postponing) another financial crisis.
Guidelines. Banks, whether acting as lead arrangers or syndication partners, are being required to categorize loans on their books to determine which loans will be affected. Loans that meet certain criteria will be deemed "criticized loans" and will carry a hefty risk insurance premium. This will drive down margins for lenders and force them to increase rates. The criteria for "criticized loans" include, among other things:
- excessive leverage, defined as an EBITDA multiple over a certain level (6x is being discussed);
- inability to fully amortize all senior debt or half of total debt (including real estate, presumably) within 5 to 7 years out of cash flow; and
- lack of meaningful covenants to protect lenders in distressed situations ("covenant lite" loans).
At this time, the specific details behind the criteria are not exactly clear. For example, if a loan meets only one criterion, is it "criticized"? Or does it have to meet all three? How do the regulators specifically define EBITDA? Are any adjustments to the EBITDA calculation allowed? How many "criticized" loans might a bank be allowed to carry? Will one criterion carry more weight than another? How will off-balance-sheet obligations be treated? Is there a size limit that subjects a loan to the test?
We believe that a meaningful percentage of loans in today's franchise lending marketplace would qualify to earn the "criticized loan" status.
Impact. How will these new regulations affect the future for a business desiring to expand through acquisitions and organic growth, as well as its ability to finance such transactions? While it is impossible to predict exactly how this will play out, it is apparent that the lending complex is likely to pull back on leverage as a result of the regulations. And lower leverage puts a damper on valuations, both today and in the future.
A basic M&A valuation axiom is "less debt availability = less leverage for deals = lower transaction prices." It may take some time, but the impact will appear. And while this may appear to be counterintuitive at first, it stands to reason that a seller's decreased future price expectations can bring valuation closer to a buyer's present price expectations. This would likely lead to increased deal activity in the near future as sellers realize they are at or near peak valuation.
Again, what this translates into for a business owner is that banks will be able to lend less money per transaction than previously. This pullback will likely have a somewhat negative effect on franchise business valuations going forward.
Market actions. Private equity insiders cite the new regulations as a huge obstacle to overcome in terms of transactions currently in the pipeline that require financing, as lenders hesitate to follow through with commitments as predictably as they had in years past. Regulators have publicly stated that curbing private equity risk is an intended consequence of their actions. On the other hand, private equity may be in a position to fill some of the void left by the banks, simply by becoming new lenders to select borrowers in need of debt. Hedge funds and non-regulated lenders are already filling this gap, and we expect them to get more aggressive as they can offer speed and flexibility in exchange for higher rates and fees.
Banking insiders say they are very uncomfortable with the uncertainty surrounding the new, stricter requirements, and this is having a chilling effect on new leveraged lending opportunities.
As a result of the regulations, we expect that loan costs will rise. How much they will rise is yet to be determined. There will also be less capacity for high leverage as banks limit the number of "criticized" loans they make. In addition, banks will be forced to require higher fees and higher rates to compensate for the risk of running afoul of the regulatory constraints and drawing attention to the institution itself. Any loan has to provide the lender a reasonable return, including compensation for the risk of increased scrutiny.
We expect increased lending rates to put downward pressure on valuations. We further expect that the specter of decreasing values could result in a flood of M&A activity in an effort to lock in to today's valuations.
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