Select Committee on Treasury Written Evidence

Memorandum submitted by Citigroup Global Markets Ltd


    —  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 risk assessment.

    —  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 lending policies.


  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 of debt".

  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 structured.

  1.5  To assist the reader a glossary of terms is included at Appendix 1 at the end of this memorandum.

2.  CITI

  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 business.


  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, the UK.

  3.2  The European leverage loan market spans Europe (Fig. 1 below) and many industry sectors (Fig. 2 below).

Figure 1

  Source: Standard & Poors LCD European Leverage Loan Review.

Figure 2

  Source: Standard & Poors LCD European Leverage Loan Review.

  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.

Figure 3

  Source: Standard & Poors LCD European Leverage Loan Review.


  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.

Figure 4

  Source: Standard & Poors LCD European Leverage Loan Review.

  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 and CDOs.

  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.


  5.1  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.[112] Fig. 5 below shows the fluctuation in overall leverage ratios over the period 1999-2007.

Figure 5

  Source: Standard & Poors LCD European Leverage Loan Review.


  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 lenders.

  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 EBITDA);

    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[113]. 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.


  7.1  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;

    (b)  material contracts;

    (c)  intellectual property;

    (d)  employment matters;

    (e)  litigation;

    (f)  real estate; and

    (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.

June 2007

112   Source: Standard & Poors LCD European Leverage Loan Review. Back

113   Source: Standard & Poors LCD European Leverage Loan Review. Back

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