Current State of the Leveraged Loan Market

Current State of the Leveraged Loan Market

On , the Securities and Exchange Commission’s Investor Advisory Committee held a hearing to discuss the risks of increased leverage in the loan market and the potential impact leveraged loans and collateralized loan obligations (CLOs) could have on the broader economy. The Committee sought to identify systematic risks to the market, noting areas of concern and recognizing regulatory implications. The risks identified by panelists included covenant-lite loans, regulatory capital arbitrage, and inconsistent definitions of EBITDA.

The leveraged loan and CLO markets are performing well, and there appears to be more discipline on overall leverage levels than there was in the years leading up to the 2007 financial crisis. Concern, however, remains among financial regulators. These concerns can be distilled into three elements:

  • Covenant-lite loans have eliminated the early warning system that would alert a lender to a borrower’s declining economic health and removed the ability for a lender to reassess the loan or potentially intervene before a borrower defaulted.
  • Regulatory capital arbitrage has allowed institutions to manipulate levels of risk and capital, and increased competition among rating agencies has led to rating shopping and raised questions regarding the accuracy of leveraged loan ratings.
  • Inconsistent definitions of EBITDA across loan agreements make the ability to assess the true health of the leveraged loan market difficult.

In conjunction with these risks, panelists identified potential remedies, such as SEC regulation of loans as securities and rating agency regulation

The panel gave an overview of the current state of the leveraged loan market. Of the $2 trillion in outstanding loans, $1.3 trillion is held by institutional lenders. In 2019, the average leveraged transaction has total leverage of 5.5 times, with approximately 4.6 times coming from first lien loans. Although leverage levels have been drifting higher, there is not a wholesale return to the 8.0 or 9.0 times, and sometimes higher, leverage that existed in 2007. Further, looking at the highest 20 percent of leveraged borrowers, today, the average leverage is about 7.75 times, with approximately 5.25 times coming from the first lien. By comparison, before the 2007 financial crisis, the highest 20 percent of leveraged borrowers had an average leverage of about 8.5 times, with approximately 5.6 times coming from the first lien.

The total of outstanding leveraged loans is estimated to be just under $2 trillion

Generally, there is more discipline on overall leverage levels in the current market than 12 years ago. Of the 15 most recent large leveraged buyouts, there was only one deal with leverage more than 7.5 times. In contrast, in 2007, 10 of the 15 largest deals had leverage of that magnitude. Today, to conduct deals, large equity checks are required, with average equity percentage now reaching the high thirties (as opposed to the low twenties in 2007). Default rates remain low.

A panelist at the Committee meeting opined that the most significant factor that could affect the loan market on a systematic basis is the large supply of loans for sale, which, if it were to exceed demand, could result in the repricing of the market. The primary component of that supply is the forward calendar of fully committed transactions because this is the portion of the calendar that has to close, regardless of market conditions. Arguing for the health of the , the committed calendar for leveraged finance (loans and bonds together) reached $485 billion, with a large percentage of that market held in “weak” or “at-risk” holders, such as open-end mutual funds, total return swaps, mark-to-market CLOs, and warehouses. Conversely, today, the committed calendar is only $60 billion and has not exceeded $100 billion since the financial crisis. Moreover, there are far fewer weak holders, both notionally and as a percentage of the atically , but down from their recent peak last year; mark-to-market CLOs no longer exist, and the number of CLO warehouses has been significantly reduced.


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