Memorandum submitted by Citigroup Global
Citi welcomes the opportunity to
respond to the Committee's enquiry into private equity funds.
Citi is an international banking institution with a major presence
in the UK. Citi arranges, underwrites, provides and syndicates
loans in the European leverage loan market.
After a reducing trend in leverage
ratios in the period 1999-2003, there has been a steady upward
trend in the period 2003-2007. Leverage levels are a function
of many factors in a dynamic market and only one structural element
of credit which requires to be considered as part of an overall
There have, to date, been few covenant
lite loans launched in the European leverage loan market. While
more are expected shortly, it is too early to say if this structure
will become a permanent feature of that market, and, if it does,
where the boundaries will be drawn. However, the participation
in the European leverage loan market in recent years of a broader
and more diverse group of lending entities, with different risk
and reward expectations, has resulted in greater liquidity.
Citi (in common with other market
participants) manages its exposure to private equity by reference
to individual obligor limits and on a portfolio basis, by reference
to a number of criteria in order to ensure that it is not over-exposed
to any particular sector or credit. Citi has what it considers
to be robust lending criteria and credit approval policies and
rigorously analyses private equity LBOs (as any other lending
transaction) in order to ensure that they meet these prudential
1.1 Reference is made to the letter of the
Rt. Hon. John McFall M.P. to Mr William Mills, Citi's EMEA CEO,
dated 14 June 2007.
1.2 The Treasury Select Committee is undertaking
an enquiry into private equity funds as part of its work under
the theme of "Transparency in Financial Markets and the Structure
of UK plc".
1.3 The Treasury Select Committee has asked
Citi to provide information on:
1.3.1 Leverage in private equity LBOs;
1.3.2 "Covenant lite" loans; and
1.3.3 Risk assessment by lenders in relation
to private equity LBOs undertaken "prior to the issuance
1.4 Before addressing the specific issues
raised in the letter we believe it will be helpful to provide
some contextual information about Citi, its participation as an
arranger and provider of loans in the European leverage loan market,
and the way in which a private equity LBO financing is currently
1.5 To assist the reader a glossary of terms
is included at Appendix 1 at the end of this memorandum.
2.1 Citi provides consumers, corporations,
governments and institutions with a broad range of financial products
and services, including consumer, commercial and investment banking
and private wealth management and transaction services. With some
325,000 employees, Citi has a presence in more than 100 countries
and more than 200 million customer accounts.
2.2 The UK is within the bank's Europe,
Middle East and Africa (EMEA) region, with around 11,000 employees
based in the United Kingdom and primarily in London. The business
has a presence in 51 other countries across the region, ranging
from Iceland to South Africa to Pakistan. Citi's EMEA regional
headquarters is in London.
2.3 Citi's major business divisions are
Markets & Banking, Global Consumer Group, Global Wealth Management
and Alternative Investments. Private equity coverage and leverage
finance operations largely sit within Citi's Markets and Banking
business and, within that, LBO financing forms part of the work
of Citi's European Financial Entrepreneurs Group (FEG) which serves
approximately 120 focused sponsor client accounts. However, as
exceptions to that, private equity investment resides in the Alternative
Investments Division which has hedge funds, real estate and some
private equity, and Global Wealth Management also extends credit
to private equity firms.
2.4 Citi has three principal legal vehicles
in the UK: (i) Citigroup Global Markets Limited which has broker-dealer
assets of approximately $300 billion; (ii) Citibank International
plc with assets of approximately £30 billion; and (iii) a
branch of Citibank, N.A., a US national bank and OCC regulated
entity, with assets of approximately $320 billion. Citibank, N.A.
is the principal vehicle for Citi's bank lending and syndication
3. CITI'S LEVERAGE
3.1 Citi acts as an arranger, underwriter
and provider of loans in the European leverage loan market. While
Citi executes this function in London, the borrowers are located
in different parts of Europe, the private equity investors are
international institutions, and the ultimate holders of the loans
are a range of banks and other entities located inside and outside,
3.2 The European leverage loan market spans
Europe (Fig. 1 below) and many industry sectors (Fig. 2 below).
Source: Standard & Poors LCD European Leverage
Source: Standard & Poors LCD European Leverage
3.3 Syndicated loan facilities for a typical
European private equity LBO are primarily sourced in the European
leverage loan market. In 2000, there were very few non-bank participants
in the European leverage loan market. However, in recent years,
a broader range of institutions and funds (hedge funds, CLOs and
CDO's) have increasingly participated as lenders in the European
leverage loan market and now, in 2007, there are over 250 active
non-bank lending entities. This "institutionalisation"
of the European leverage loan market, which is illustrated in
Fig. 3 below, is creating additional liquidity and demand for
leveraged capital structures. In addition, because the different
lending communities have differing risk and reward expectations,
it is also allowing much greater flexibility in the capital structuring
of an LBO.
Source: Standard & Poors LCD European Leverage
4.1 With the increasing institutionalisation
of the European leverage loan market, there are a wide variety
of market participants with varying approaches to risk and reward.
Consequently loans can be provided at different levels ranging
from, at one end of the spectrum, senior loans protected by first
priority security and significant covenants to, at the other end
of the spectrum, PIK loans which are typically unsecured, and
which incorporate loose covenant protection, few, if any, enforcement
rights and the capitalisation of interest. In between, there are
a number of other loan categories such as "second lien"
and "mezzanine". Each "category" will have
a different level of security cover and covenant protection and,
of course, the rate of return will vary to reflect the perceived
level of risk. As the market is dynamic, and the "risk reward"
appetite of loan providers fluid, the structures under which loan
finance is provided are themselves constantly developing.
Fig. 4 below illustrates how, as the European
leverage loan market has become institutionalised, the loan finance
components of European LBOs have changed.
Source: Standard & Poors LCD European Leverage
4.2 In a private equity LBO, the private
equity firm(s) will typically develop a capital structure which
will include a number of different levels of loan finance, and
approach a number of banks to underwrite and arrange these facilities.
As one such bank, Citi's role would be to underwrite each of these
facilities, to participate in the negotiation of the terms of
these facilities and ultimately, in the case of a successful transaction,
to fund the facilities at the time the transaction is closed.
The underwriting commitment will typically need to be in place
to support the bid of the private equity firm(s) and loan documentation
will be concluded prior to the closing and funding of the transaction.
4.3 During the initial stages of the transaction,
the group of arranging banks may expand to include additional
banks and, subsequently, the loan facilities are often further
syndicated to a broader group of lenders in the primary market.
Each category of loan will include certain rights allowing transfer
subject to agreed restrictions and, within these restrictions,
will often trade in the secondary market. Consequently the debt
will ultimately be held by a fluid community of market participants
ranging from banks and other financial entities to funds of one
kind or another such as hedge funds, insurance companies, CLOs
4.4 As part of Citi's underwriting process,
a full internal credit approval and risk assessment process and
due diligence is undertaken in order to ensure that a transaction
meets Citi's prudential lending policies. In addition to Citi's
own due diligence process, the private equity firm(s) generally
will additionally make available the product of their due diligence,
which will typically include a number of external reports.
4.5 A fuller description of the risk assessment
and due diligence process is provided in Section 7 below.
5. LEVERAGE RATIOS
5.1 Leverage ratios typically reflect the
amount of debt as a multiple of EBITDA (earnings before interest,
tax, depreciation and amortisation) of the underlying business.
They are a common shorthand for comparing financings but they
are only one of many factors that are taken into account in assessing
credit risk. In particular, while the overall ratios are important,
in a complex financing structure involving different levels of
senior and junior debt, each group of lenders will assess the
robustness of the cashflow forecasts and where its right to debt
amortisation ranks as against other creditors and groups of lenders
and the relative enforcement rights of the different lending groups.
The detailed debt and equity capital structure of the borrower
is an essential part of this assessment.
5.2 Leverage ratios (that is total debt
to EBITDA) for LBO financings have fluctuated over time and, after
reducing in the period 1999-2003, have followed an upward trend.
In 2006, total leveraged loan volume in Europe was EUR 131.3 billion
from 278 deals. In 2005, it was EUR 123.5 billion from 197 deals.
In the first quarter of 2007, overall leverage ratios were 5.7x.
In 2006, total leverage ratios were 5.5x. The comparative figures
for 2005, 2004, 2003 and 2002 were, respectively, 5.2x, 4.5x,
4.1x and 4.1x. All the ratios in this paragraph are average figures;
for larger, stronger and more familiar credits, the leverage ratio
may be higher.
Fig. 5 below shows the fluctuation in overall leverage ratios
over the period 1999-2007.
Source: Standard & Poors LCD European Leverage
6. COVENANT LITE
6.1 Leverage loan documentation includes
a broad range of covenants which oblige the borrower to conduct
its business so as not to breach those covenants. These covenants
will include covenants which are related to the financial condition
of the borrower. A breach of covenant can, subject to cure rights,
constitute a default which may permit the lenders to withhold
further advances under the loan facilities, so limiting the borrower's
ability to raise incremental debt, and/or to place the loan on
a demand basis, so giving rise to the possibility of a financial
restructuring which may ultimately maximise the value to senior
6.2 Although difficult to define, covenant
lite loans are understood, at the most basic level, to be loans
where the covenants related to financial condition are structured
as financial incurrence covenants rather than the more traditional
financial maintenance covenants.
6.3 At the most fundamental level, maintenance
covenants require a borrower to meet certain financial covenants
periodically, typically every financial quarter. The most common
financial covenants are:
6.3.1 leverage (financial indebtedness to
6.3.2 interest cover (EBITDA to either net
or gross interest payments); and
6.3.3 cash flow cover (adjusted EBITDA against
total funding costs).
6.4 Incurrence covenants generally work
to restrict a borrower from doing certain things (eg borrowing
more money, making an acquisition or making a distribution), if,
after doing such things, it would not be in compliance with certain
financial ratios. However, if a borrower were simply to breach
a ratio because, for example, its EBITDA had deteriorated, this
would not be a breach of a covenant leading to a default.
6.5 While recently becoming more common
in the US leverage loan market, covenant lite deals are relatively
new in the European and US leverage loan markets. As at 31 March
2007 Citi was aware of only three pure (incurrence covenants only)
covenant lite deals launched in the European senior bank loan
market, namely VNU World Directories, Trade Media and Jupiter.
However, there are others (not yet launched) which are expected
to be structured on a covenant lite basis. The European leverage
loan market is still viewing this type of deal on a case by case
basis with a view to determining whether it meets credit criteria
and lending guidelines. This is resulting in some hybrid or "covenant
loose" loans which are based on more traditional loan documentation
without one or more of the traditional maintenance covenants.
6.6 The purpose of a maintenance covenant
is to give an "early warning" trigger and an opportunity
to senior lenders to discuss with the borrower and private equity
investors whether or not a breach is indicative of a serious underperformance
of the business affecting the credit quality of their loan. As
indicated in Section 6.1, if the situation is serious, the senior
lenders would be in a position, following the triggering of the
covenant, to withhold further drawings and to force a financial
restructuring to maximise value for senior lenders. Alternatively,
the discussion may result in some form of waiver of the breach
"on terms" in order to afford the borrower some stability
and protection from cross-default, while it sought to improve
performance, and some adjustment to interest margins.
6.7 The diversification and institutionalisation
of the loan market has made it more difficult for a borrower to
conduct a conversation of this kind with all its lenders. Where,
historically, those lenders were largely banks today, as described
earlier, they will comprise different communities of lenders with
different expectations and interests. Consequently a trend has
developed in recent years of building into loan documentation
cure rights and delayed covenant testing the effect of which is
to postpone the point in time at which senior lenders can assert
their voice and to allow the borrower, and the private equity
sponsors, more control over the situation. In addition, there
has also been a trend to loosen, and even dispense with, some
of the covenants.
6.8 A covenant lite structure is a next
step which continues this trend and since the pure covenant lite
loan dispenses with maintenance covenants altogether, it may postpone
significantly the point in time at which the senior lenders can
assert their voice (even though they may be on notice of a deterioration
in the financial condition of the borrower). Whilst this permits
a period of stability for a borrower to improve its performance,
nevertheless the borrower will be in a position, during this period,
to continue to draw under the loan facilities and this may result
in a further erosion of business value (through the funding of
losses with these additional borrowings in an attempt to turn
the business round). It is in this sense that a covenant lite
structure represents a further loosening of credit protection.
6.9 Re-enforcing the market's recent tendency
to consider covenant lite structures are two further points:
6.9.1 The private equity investors do have
significant incentive to correct underperformance by a borrower,
both in order to earn their return and to maintain their credibility
with the European leverage loan market; and
6.9.2 A borrower is in any event required
to service interest payments throughout the life of the deal and
to repay principal (either through cash generated by the business
or a refinancing). If the borrower is unable to do this, a default
will occur, whether the loan is "covenant lite" or not.
6.10 Finally, it is important to emphasise
that a covenant lite structure affects only the maintenance covenants
referred to above. The loan documentation will continue to incorporate
significant and detailed covenants affecting the borrower's conduct
of its business generally (negotiated on a case by case basis
but covering such matters as the provision of detailed financial
information and restrictions on acquisitions and disposals, incurrence
of capital expenditure, and the making of distributions), and
detailed events of default the occurrence of which will allow
the lenders to take action, as described in Section 6.1 above.
For a more detailed explanation of the type of matters which will
be covenant controlled in a covenant lite loan (as well as a more
traditional loan) in the European leverage loan market, see Appendix
2 at the end of this memorandum.
7. RISK ASSESSMENT
7.1 Citi has what it considers to be robust
lending criteria and credit approval policies. Transactions are
analysed by Citi and its due diligence is carried out in accordance
with Citi Markets and Banking Credit Risk Principles, Policies
and Procedures and requirements laid out in other business specific
guidelines, in order to ensure that the transaction meets these
prudential lending policies. This process is complex and rigorous
and many factors will be taken into account by Citi in order to
assess the quality of the transaction, in the context of the then
current market conditions. These will include Citi's views on
the quality and track record of the management, the quality of
the financial sponsors, the robustness of the capital structure,
the strength of the projected cashflows and their ability to service
the debt and support the business plan.
7.2 Generally, Citi's own risk assessment
of a transaction will be supplemented by independent due diligence,
commissioned by the private equity firm(s). The composition of
this will vary from transaction to transaction but may include:
7.2.1 Accountant's Report. This would be
prepared by one of the major four accounting firms, and would
normally review in detail the financial position of the group
on the basis of historic accounts and financial information provided,
including financial projections.
7.2.2 Legal Due Diligence Report. This would
be prepared by the private equity firms' lawyers and may cover,
amongst other things:
(a) corporate documentation;
(c) intellectual property;
(g) any particular regulatory issues.
7.2.3 Pensions Report. This would review
the group's pension arrangements.
7.2.4 Environmental Report. This would cover
compliance with environmental laws and regulations, and may contain
recommendations for compliance going forward and their cost.
7.2.5 Insurance Report. This would look at
the suitability of the group's insurance arrangements.
7.2.6 Market Report. This may be commissioned
to understand better the market in which the company operates,
or the future of that market, or the company's competitive position
in that market.
7.3 Historical financial information as
well as the latest available audited and unaudited accounts are
made available by the private equity firm to lenders together
with a budget and business plan. The budget and business plan
are typically reviewed by the reporting accountants and set out
in some detail the financial projections for the business over
the life of the borrowings. Typically, arrangers (and lenders)
would meet with management of the business to discuss the business
plan and other key aspects of the business. Management of the
business will typically invest alongside the private equity firm
and so these interests will be aligned in ensuring the business
is a success.
7.4 Other due diligence type material provided
by the private equity firm would typically include a group structure
chart, structure memorandum and funds flow memorandum.
7.5 The due diligence commissioned by the
private equity firm is detailed and extensive and made available
to the lenders and, generally, can be relied upon by the lenders
who are then responsible for making their own critical assessment
of it and of the credit.
112 Source: Standard & Poors LCD European Leverage
Loan Review. Back
Source: Standard & Poors LCD European Leverage Loan Review. Back