IOSCO consults on proposed Good Practices for Leveraged Loans and CLOs

On 14 September 2023, IOSCO published a Consultation Report, "Leveraged Loans and CLOs. Good Practices for Consideration" (the CP). The consultation period closes on 15 December 2023 and will lead, in due course, to a final Good Practices Report.

What's the background?

The structure of Leveraged Loans and the Leveraged Loan market itself have evolved markedly since the global financial crisis and both the Leveraged Loan and Collateralized Loan Obligation (CLO) markets have experienced significant growth globally, thanks to an expanding economy and low interest rate environment.

IOSCO has been following the evolution of the Leveraged Loan and CLO markets, looking, in particular, at

• the impact of fewer covenants on investor protections
• whether the two markets have adequate transparency in and
• whether potential conduct-related issues have arisen as a result of recent market developments.

and believes that it has identified some vulnerabilities in the Leveraged Loan and CLO markets which may be exacerbated by the behaviour of certain participants and market practices.

The CP seeks views on 12 proposed Good Practices intended to address these vulnerabilities and additional consultation questions (set out in Section 3 of the CP) on each of the measures.

The good practices are not formal IOSCO Standards or Recommendations but are, instead, designed to "support market participants in their decision making" when operating in the Leveraged Loan and CLO markets.

Following review of the responses received, IOSCO will publish a final Good Practices Report.

What are the proposed Good Practices?

The Good Practices are grouped into five themes, which, together, contain 12 separate measures. Looking at each in turn:

Theme A Origination and refinancing based on sound business premise

Measure 1 Debt repayment capacity test

• leveraged loans offered to the market should be underpinned by sound business and financial risk assumptions
• borrowers should be able to demonstrate sufficient debt repayment capacity, (i.e, the ability to repay 100% of senior debt or 50% of total debt over the medium term). Where this is not evident, a credible explanation should be provided
• debt repayment capacity should be disclosed in term sheets and supporting documentation at the time of debt offering and refinancing. A robust assessment of cash flows including stress testing should inform debt repayment capacity assessments

Measure 2 Dividend Recapitalisations

• dividend recaps should be considered with reference to the level of
• remaining equity support
• degree of leverage and
• debt repayment capacity
• the use of incremental debt to affect a dividend recap should be limited
• the clear disclosure of dividend distribution policy and strategy by borrowers is encouraged

Measure 3 Enterprise Values (EVs)

• EVs which support the capitalisation structures of LBOs should be calculated based on a well-constructed financial model and underwriting entities should clearly disclose the key assumptions underpinning the financial model
• EV models should be reviewed and validated by a function independent of the origination unit and the basis for EV should (where possible) be under-pinned by multi-year forecasted cashflows rather than based only on comparable multiples of Earnings before interest, taxes, depreciation and amortization (EBITDA) derived from other LBO transactions
• where DCF valuations are "heavily influenced" by terminal values extrapolated from final year forecasted cashflows, these should be credible and challenged

Theme B EBITDA and loan documentation transparency

Measure 4 EBITDA complexity and opacity

• EBITDA definitions should not be unnecessarily complex
• pro-forma EBITDA adjustments based on future synergies, earnings and asset disposals should be made on a reasonable basis with clear justification for these adjustments
• forecast cost savings and synergies should be subject to prudent time horizons and caps
• EBITDA adjustments should be subjected to independent review by an appropriate second line control function as part of the underwriting process and be periodically back-tested

Measure 5 Transparency on covenants' limitations

• material covenants and associated terms should be contained in term sheets.
• loan documentation should be written and presented in a clear, concise and effective manner that can be readily understood by the contracting parties - it should include the circumstances under which covenants can be triggered
• best practice guidance for transparency should be considered when drafting key marketing materials, such as term sheets
• marketing materials should clearly disclose key terms that could materially impact a borrower's credit risk - including terms that could result in subordination of lenders
• clear disclosures should be provided of the quantity of incremental debt and associated baskets that can be raised and the ability to move assets beyond the lender group's reach
• detailed disclosures of key risks could be provided in a loan document

Theme C Strengthening alignment of interest from loan origination to end investors

Measure 6 Transparency and fairness during underwriting and syndication

• underwriting entities are encouraged to:
• provide investors with sufficient and clear information early in the syndication process so investors have sufficient time and opportunity to negotiate and make well-informed investment decisions
• review the full loan documentation thoroughly before signing the commitment letter and to negotiate so that they are happy that the risk, should a syndication fail, is within their risk appetite
• provide investors with anonymised feedback on documentation points in a transparent way
• highlight to investors new flexibilities built into loan documentation as well as those which the investor base has previously opposed

Measure 7 Alignment of interest between underwriting entities and investors

• underwriting entities should demonstrate how they have aligned their interests with leveraged loan investors, whether through risk retention or otherwise
• robust risk management of leveraged lending activities can both strengthen alignment of interests and prevent the build-up of systemic risks
• underwriting entities and leveraged loan investors should obtain independent, impartial legal advice which represents their interests and strengthens their ability to negotiate loan terms and influence market evolution.

Theme D Addressing interests of different market participants throughout the intermediation chain

Measure 8 Reducing restrictions on transferability of loans

• loans should be as widely transferable within a pool of potential investors as possible to support a liquid secondary market
• where lists of approved and disqualified lenders are used, these should only be created based on clear and documented reasons
• investors should be provided with transparency on transferability restrictions and how these might evolve during the loan's life early in the syndication process
• in particular, investors should be provided with sufficient clarity on the precise definition of an event of default, where this would cause limitations on transferability to no longer apply

Measure 9 Managing conflicts of interest where PE sponsors also act as lenders

• conflicts of interest arising from a group's investments in different parts of a borrower's capital structure, should be appropriately identified and managed
• participants in a syndication and leveraged loan investors should be properly informed of when a group is acquiring the debt of a borrower while also acting as the borrower's sponsor (or holding other classes of that borrower's debt)
• in such cases, a sponsor disenfranchisement or similar clause should be used

Measure 10 Managing conflicts of interest in management of CLOs

• potential conflicts of interest in managing CLOs should be appropriately identified and managed
• policies governing the purchase of distressed assets, cross-sales and trading / valuation of CCC/Caa rated loans should be clearly set out in a CLO indenture, so investors can make an informed investment decision
• trustee reports should regularly disclose a CLO's trading activity and valuation of assets in order to enhance investor transparency
• investors should be given sufficient opportunity to conduct due diligence on the CLO manager's valuation methodology and results and to assess the strategy and rationale for asset management when performance tests are at risk of being breached

Theme E Disclosure of information on an ongoing basis

Measure 11 Disclosure in CLOs

• CLO investors should be provided with all materially relevant information on the valuation, credit quality and performance of the portfolio of a CLO
• this data should be made available regularly to CLO investors (e.g., monthly) so they can make an informed judgement of their investment decisions
• potential CLO investors should be provided access to such information upon request

Measure 12 Disclosure on underlying loans

• leveraged loan borrowers should provide investors with their latest financial information and status on a timely basis
• they should also inform their investors within a reasonable timeframe if an event occurs that may invalidate any assumptions originally applied in the EBITDA addbacks.