Leverage on buyouts in the U.S. continues to rise in 2018, with roughly 53% of leveraged deals for large corporate borrowers having pro forma leverage of 6x or more, a post-crisis high, according to Leveraged Commentary & Data.
The record came in 2007, when 61% of buyouts had leverage that high, and 2014 was close, with 52% of deals.

The 6x leverage figure is notable given that the 2013 federal leveraged lending guidelines stipulated that loans with debt to EBITDA topping 6x "raises concerns" from regulators. In late 2017, these guidelines were deemed subject to congressional review by the Government Accountability Office, creating the possibility — or expectation, even — that the guidelines would be overturned.
The guidelines are in the headlines once again due to recent comments by Comptroller of the Currency Joseph Otting stating that banks "have the right to do what [they] want" regarding leveraged lending, as long as it does not negatively impact "safety and soundness," according to Reuters.
"I will tell you that a lot of people found [Otting's recent comments] rather bold and a bit surprising, but it's also somewhat consistent with what the GAO said back in October of 2017," said Scott Zemser, partner at Mayer Brown and co-head of the firm's global lending group.
According to Zemser, who said he has started to see leverage creep higher across the board in the past six months, direct lenders have gotten more aggressive in pursuing deals in the 6.5x or 7x leverage area of late.
"Direct lending probably in the last year or two has grown to almost 20% of the leveraged market, according to financial metrics released by major reporting publications," he said. "The real question is: What does this all mean? Are banks going to become more aggressive and have more flexibility to lead or participate in the highly leveraged deal? The short answer is there certainly is that movement already."
Against this changing backdrop, nonregulated lenders have commanded much attention, as those entities make further inroads into the asset class, particularly on deals entailing private equity sponsors. While transactions arranged by these lenders represent a small share of overall activity, there has been a noteworthy difference in leverage. In 2017, LBOs arranged by lenders not subject to the guidelines had an average debt to EBITDA ratio of 6.4x, nearly a full turn higher than those arranged by regulated entities.

Moreover, this one-turn gap remains intact regardless of company size.
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Of course, if the guidelines do fall by the wayside, it will be interesting to see if the market share gained by unregulated entities begins to ebb.
Debt cushion shrinks
Leverage through the first-lien portion of the debt structure has also risen to a record high, ballooning to 4.8x in 2018. That could impact recoveries in the asset class when the credit cycle turns; historically, the larger the debt cushion, the higher the recovery for a senior asset when there is a default, according to LCD.
In 2007, at the peak of the last credit cycle and shortly before the financial crisis, first-lien debt accounted for an average of 4.1x EBITDA in LBO financings. After retreating to a 3.2x low in 2009 — when there was no LBO activity to speak of in what was a decidedly post-crisis risk-off market — the average has crept higher largely year by year.

First-lien term loans have accounted for 82% of overall debt raised to fund buyouts so far this year, the highest share ever, and up from roughly 76% in the prior three years.
Slow-moving ship
Ultimately, says Frederick Fisher, partner at Mayer Brown and co-head of that firm's global lending group, with more competition between banks and direct lenders, you're going to see "the best rise to the top," with new entrants to the credit market potentially suffering.
Even if banks do opt to get more aggressive as time passes, deals — no matter their leverage level — have to make it past banks' credit committees and risk committees, meaning that a 6.5x to 7x leverage level in one industry might not generate concern, while in another it will not get done, Zemser said. "The second part of that is, can you sell these deals into the marketplace? The funds, the CLOs, are they comfortable with this leverage?"
Bottom line: The shifting attitude toward leverage guidelines will not be quick.
"Banks are going to move more slowly on this than a debt fund," Fisher says. "It's going to be more like turning a large ship. Whether they stick to 6x as an official policy or [make exceptions] on a one-off basis, is going to vary from institution to institution. There's going to be a bit of secret sauce there — it's not going to be sort of a message that they telegraph to the market."
LCD is an offering of S&P Global Market Intelligence.

