Select Committee on Treasury Written Evidence

Memorandum submitted by UBS Investment Bank

  1.  This memorandum responds to the Treasury Select Committee's invitation to "provide information on the issue of excessive leverage in private equity deals, the increasing role of "Cov-lite" loans and the risk assessments of private equity LBOs undertaken prior to the issuance of debt."

  2.  I am writing in the capacity of Chairman and CEO of UBS Investment Bank and a member of the UBS Group Executive Board, both roles that I assumed in July 2005. I joined the firm from BZW (where I had been from 1987) in 1996, as Managing Director and Head of Asian Equities. In 2000 I was appointed as Head of Equities for the Americas and went on to become Global Head of Equities in 2004.

  3.  My observations reflect the experience of UBS Investment Bank as a provider of finance for private equity deals. These observations focus on the European market (for which London acts as a hub) which is driven to some degree by global trends, principally in the much larger US market.


  4.  The level of leverage used in private equity deals has increased in recent years as a result of the low interest rate environment and the stable economy amongst other factors.

  5.  The number of default triggers (referred to as "covenants", which enable lenders to enforce a default if the borrower's underlying performance fails to meet the requirements under the covenants) has fallen in recent years, reflecting competition by banks in this market, although pure "Cov-lite" loans remain rare in Europe.

  6.  Robust due diligence remains very important for banks underwriting the initial finance for private equity deals (and indeed to the ultimate investors in the debt following the syndication process). Notwithstanding increased leverage and documentation with fewer covenants, we have witnessed little erosion of diligence standards.


  7.  Relevant Standard and Poor's (S&P)[114] data is presented in Charts 1 and 2.

  Chart 1 presents annual data on a number of key ratios[115] including Debt/EBITDA (known as the Leverage Multiple) and several coverage ratios (eg EBITDA/Cash Interest) which focus on a company's ability to meet its debt payment obligations. It shows a rise in average leverage ratios (see Debt/EBITDA and Senior Debt/EBITDA) and a decrease in average coverage ratios (see remaining ratios) over recent years, in particular from 2001-05.

  Chart 2 records the rise in the proportion of deals (by volume) with leverage in excess of six times, eg from 4% in 2001 to 37% in 2007 Q1.

  8.  Several interrelated factors have contributed to higher leverage ratios, including historically low interest rates, strong economic growth, record institutional liquidity, higher business and asset valuations and the low incidence of default.

  9.  Higher enterprise valuations, together with strong primary and secondary market liquidity, have facilitated successful syndications. Underlying business cash-flows continue to support the amount of debt being provided, albeit with less margin for error.

  10.  Private equity deals are increasingly structured with less contractual amortisation and subordinated debt tranches carry a larger capitalised interest element than hitherto. These trends have allowed private equity deals to assume higher leverage, which has given rise to a number of potential risks:

    —  First, higher leverage has the potential to increase refinancing risk upon the maturity of the loans or resale of the business.

    —  Second, an unexpected acceleration in interest rates would produce knock-on effects to economies, and thus to underlying businesses, reducing their ability to service debt. Related to this, a reversal of current valuation trends might slow the resale of the company and the associated retirement of the debt. As interest rates rise, the cost of debt service may also rise if the debt cost is unhedged.

    —  Third, the lack of work-out experience amongst the increased number of market participants could make it challenging to restructure LBO debt.

  11.  In the event of certain of these risks materialising, for example a marked economic slowdown and/or a sharp interest rate hike, the debt servicing burden for private equity deals could become harder to sustain. Regulators worldwide are currently giving these issues proper consideration.

  12.  The FSA has declared its intention to step up monitoring of lending to private equity deals, by modifying its survey of banks' exposures to leveraged buy-outs and conducting it on a semi-annual basis. It has also underlined the importance of supervising lenders' systems and controls in this environment.[116] This should enable the FSA to better monitor trends in leveraged finance and pursue its core aims, including its promotion of orderly and fair markets, in line with its statutory objectives, which include "maintaining confidence in the financial system."


  13.  The advent of "Cov-lite" (ie covenant-lite) loan structures has been driven by the US market where such structures have become more common (approximately 30% of new-issue volume in 2007 to date). However, we believe Europe has only seen a few Cov-lite deals launched in 2007.

  14.  A number of deals have been launched in the European market which are neither truly Covenant-lite nor fully covenanted. They have instead been based on traditional loan documentation, but with one or more of the traditional maintenance covenants (eg Debt/EBITDA) removed. In others, more headroom has been allowed in respect of maintenance covenants (eg 30% instead of 20%), allowing the private equity deal more scope to increase its leverage and/or reduce its collateral without triggering the lender's right to declare default[117].

  15.  In response to the recently increased use of Cov-lite loans in leveraged buyouts, S&P announced on 12 June that it would revise Loss Given Default weightings (ie the estimated recovery on a loan in the event of default) to reflect S&P's expectation of increased loss exposure on Cov-lite obligations. The market's response has been immediate, predominantly driven by the Collaterized Loan Obligations industry whose loan portfolios are governed by ratings. In the past two weeks the US market has seen a number of deals re-introduce maintenance covenants, and yields in the secondary market for Cov-lite loans have risen commensurately. Indeed at the time of writing, the US Cov-lite market is effectively closed. We expect the European market to follow the US lead in further pushing back on the use of Cov-lite structures.

  16.  In general, following this current market correction, we expect the usage of Cov-lite loans to become even more selective, with such structures only being applied to more stable businesses and with lower leverage than that applied to deals with maintenance covenants.

  17.  Regulators should continue to monitor this situation.


  18.  In general, our experience is that the level of risk assessment and due diligence conducted by lead underwriters prior to their committing to financing remains robust; it includes a thorough review of the diligence reports carried out by the vendor's third party advisors and those of the private equity fund purchasing the company.

  19.  However, given the greatly increased pool of funds available for investment by the private equity industry, the bidding tactics adopted by private equity funds have become increasingly aggressive, with many attempting to pre-empt formal M&A auction timetables. In consequence, in certain cases the time-scales which debt underwriters have to analyse due diligence materials have been shortened. This trend reinforces the importance of the internal risk management systems and controls that the banks rely on.

  20.  It should be noted that in the US market third party due diligence reports have never been provided to investors.

June 2007

  —  "Debt/EBITDA (Total Debt/Earnings Before Interest, Taxes, Depreciation and Amortization) also known as the Leverage Multiple—a good measure for analysing a company's debt burden in relation to its profitability relative to its peers within the same sector.

  —  EBITDA/Cash Interest (Earnings Before Interest, Taxes, Depreciation and Amortisation/Interest Payments)—a good measure of a company's ability to meet its debt finance obligations in the short term.

  —  (EBITDA—Maintenance Capex)/Cash Interest ([Earnings Before Interest, Taxes, Depreciation and Amortisation—Maintenance capital expenditure]/Interest Payments)—a measure of a company's ability to meet its debt finance obligations over the medium term as it takes account of the capital expenditure which is necessary to maintain the business.

  —  (EBITDA—Capex)/Cash Interest—a measure of a company's ability to meet its debt finance obligations over the long term as it takes account of the total capital expenditure needed for the business to continue operating at planned levels."

114   S&P are the main source of authoritative data on private equity. Back

115   For definitions of the main ratios including those used in the Charts, see the following extract from Page 31 of FSA Discussion Paper 06/6: "Private Equity: a discussion of risk and regulatory engagement" ( Back

116   Thus the FSA notes in paragraph 3.6 of Feedback on DP07/3 ("Feedback on DP06/6", see Footnote 1) ( that "the robustness of systems and controls will remain a focus for supervisors of leveraged finance providers." It also states in paragraph 3.30 that "a regular survey would be a valuable exercise, and in line with the perceived importance of the data set we propose to conduct the survey semi-annually." Back

117   Other things being equal a reduction in, or the absence of covenant protection, may result in diminished recovery prospects for loans relative to historic secured loan experience. This is because future defaults are unlikely to be triggered until a business is in worse condition than would previously have been the case. Back

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Prepared 22 August 2007