Payback Time

One bedrock tenet of sound lending practices is establishing the borrower’s capacity to repay its debt over the contractual life of the obligation. So it’s not surprising that regulators have taken banks to task in recent reports highlighting a growing number of leveraged loan issuers which lack that capacity.

Specifically, in its 2014 Leveraged Loan Supplement, the Gang of Three – Federal Reserve, OCC, and FDIC – cited banks in which only 77% of portfolio companies managed to show they could successfully amortize the loan over a seven-year period. That was down from 83% measured in the prior year’s examination.

Projected cash flows should indeed leave plenty of room for principal and interest payments. But a bit of perspective on the topic is in order.

To paraphrase F. Scott Fitzgerald’s observation about the rich, leveraged borrowers are different than other borrowers: they have more debt. Private equity sponsors use leverage to enhance their returns, and not every business is a good candidate for high debt levels. Premiums are paid for companies that demonstrate significant free cash flow generation.