Memorandum submitted by UBS Investment
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
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)
data is presented in Charts 1 and 2.
Chart 1 presents annual data on a number of
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
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
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.
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.
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
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
"Debt/EBITDA (Total Debt/Earnings
Before Interest, Taxes, Depreciation and Amortization) also known
as the Leverage Multiplea 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.
Interest ([Earnings Before Interest, Taxes, Depreciation and AmortisationMaintenance
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.
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
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" (http://www.fsa.gov.uk/pubs/discussion/dp06_06.pdf): Back
Thus the FSA notes in paragraph 3.6 of Feedback on DP07/3 ("Feedback
on DP06/6", see Footnote 1) (http://www.fsa.gov.uk/pubs/discussion/fs07_03.pdf)
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
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