A Brief Discussion on Toxic Loans & Why Toxic Loans Might Be Making a Comeback

We all know the story of the last crash, and there are more tales of woe than we care to remember. But the real takeaway point was we should be careful about how we lend money, and do it in a way that ensures people know what they’re getting themselves into. But what of the rumors coming out of certain corners of Wall Street that investors in leveraged loans aren’t happy with a number of private equity firms? Here are some questions answered by Matthew Ledvina. Let’s take a closer look.

What are leveraged loans?
It’s a corner of the debt market focused on lending to some of the lower-rated, riskier companies out there. They still need access to credit, and leveraged loans are what makes it happen.

Have the private equity firms done anything wrong?
A number of investors are voicing concern about the manner in which loan terms are being relaxed, and therefore opened up to an even riskier class of businesses. The fear is that this could push default and recovery rates over the cliff in the event of a recession. No matter what you feel about the manner in which the loans are structured, the doubling in size of the US leveraged loan market in the past 10 years shows the increased scale of lending. It may be a natural path to go down in a world of anemic interest rates, but will it turn things toxic once again?

What are the regulators saying?
A drop in lending standards is all it takes to get the attention of the IMF and the Fed these days, and that’s certainly the case with this corner of the market. Their primary worry is that when the economy inevitably goes through a quieter spell, the newly debt-laden companies will find it impossible to take care of their debt by restructuring.

Is the market already doomed?
These are the kinds of questions those of us who remember the last recession always ask the moment we see the word ‘toxic’ anywhere near the markets, but there’s some good news on the horizon at least. The private equity firms are required to put forward a greater slice of their own reserves when they want to do a deal than back in 2007. This makes them more risk-averse than they used to be, but how long will this mindset last?

How is the landscape changing?
The primary concern is that private equity firms are gradually removing the legal covenants (protections) that are part and parcel of creating a loan. Simply put, these are the boxes they have to tick, and the hoops they have to jump through, to be able to lend to a business.

‘Adjusted’ figures
Ebitda is the first port of call, and it’s basically a measure of determining the operating profitability of a given company. A number of companies have taken to ‘adjusting’ their figures so they appear better than they really are. With relaxed lending standards this then leads the market down a very slippy slope.

Removal of clauses
The other main area to keep a close watch over is restricted payments. These are the clauses which determine how much cash the owners can take back out of the business. With the removal of these clauses comes the ability for the private equity firms to pay themselves colossal dividends which simultaneously jeopardize the ability of the company to gain access to new sources of credit.

Final thoughts
Whilst we shouldn’t hit the panic button just yet, it’s clear a significant section of Wall Street investors are unhappy with the way the market is being restructured. A proactive approach is always more effective than a reactive approach, which is why now is the perfect time to step in and fight the corner of tougher regulation. Watch this space to see how the leveraged loans market evolves over the next 12 months.

About Matthew Ledvina

Matthew Ledvina works as a cross-border tax adviser, with US taxation among his specialities. He has worked with many high-profile clients and high-net-worth individuals. Follow Matthew Ledvina on YouTube and Instagram for future updates.

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