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Brian Franey Kevin Garcia
February 1, 2020 Article 5 min read

How well are you managing increased risk in the leveraged lending market and the M&A market? Follow these tips to protect yourself.

Younger businesswoman using desktop computer and looking intently at the monitor screen.Financial institutions are under a significant amount of pressure. They’re constantly working to balance risks and opportunities in order to manage their portfolios and drive future growth.

Below, we highlight two key areas where risks are increasing — the leveraged lending market and the M&A (mergers and acquisitions) market — and suggest activities that can help financial institutions ensure they’re managing their risks effectively.

Leveraged lending market

The leveraged lending market has seen increased stress over the past year, with a range of factors impacting potential lending decisions. Leveraged lending refers to a transaction where the borrower’s post-financing leverage, when measured by debt-to-assets, debt-to-equity, cash flow-to-total debt, or other such standards unique to a particular industry, significantly exceed industry norms for leverage.

Increasing market stress

Signs are pointing to market bifurcation — with GDP, marketing, and manufacturing factors suggesting a leveling off in the economy, while real estate prices continue to inflate. In the Midwest, for example, real estate prices are near 15- and 20-year highs. In the event a negative trigger occurs in the market, real estate values could decline very rapidly which will significantly affect loan-to-value ratios.

The economy has also experienced a flattening curve between 10-year and two-year U.S. Treasury Bond yields. At the end of November, the 10-year yield was 15 basis points away from falling below the two-year yield level, which would have resulted in a yield curve inversion. The gap between short-term interbank lending rates and comparable risk-free U.S. Treasury rates also reflected market stress.

Growing risk for leveraged lending

As a result of various economic and market issues, financial institutions have seen an increase in defaults within their leveraged loan portfolios. This has led to a tightening of credit within the leveraged lending market.

This is somewhat of a reversal from a year or two ago when community banks were looking to get into leveraged lending. Now, financial institutions are pumping the brakes — tightening up credit underwriting and suggesting that the market may experience a downturn in the short term.

What can financial institutions do to mitigate leveraged lending risks?

For financial institutions with leveraged lending portfolios, mitigating risk will become a major factor in success, particularly if market stress continues well into 2020. In order to manage  risks more proactively, financial institutions should monitor their borrowers’ financial performance more closely.

In order to manage risks more proactively, financial institutions should monitor their borrowers’ financial performance more closely.

This could include activities, such as:

  • Reviewing financials more frequently than in the past, such as reviewing a borrower’s financial results quarterly rather than annually.
  • Increasing scrutiny with accounts receivables, inventory and fixed asset capitalizations are monitored effectively to ensure credit quality is maintained, and that losses and delinquencies do not mount.
  • Monitoring accounts payables listings to ensure the borrower is not extending terms with vendor relationships.
  • Conducting more frequent meetings or site visits (i.e. biannually rather than annually or every 18 months) with borrowers to ensure the institution fully understands the customers business, any new business ventures that the customer is expending cash on not included in the lending relationship that could place stress on the balance sheet, as well as further understanding the key and their actions to mitigate risks related to their line of business.

Financial institutions that take the time to strengthen their monitoring of higher risk borrowers will be better able to manage more volatile market conditions and decrease the likelihood of future losses occurring.

Financial institutions that take the time to strengthen their monitoring of higher risk borrowers will be better able to manage more volatile market conditions and decrease the likelihood of future losses occurring.

Mergers and acquisitions market

M&A activity in the financial services sector increased significantly in recent quarters, with Q3-2019 results indicating $57.3 billion in global deal value — up 21.9% compared to Q2-2019. Over the first three quarters of 2019, global M&A value in the financial institution sector reached over $206 billion — up almost 43% compared to the same three quarters in 2018. The United States accounted for the largest share of M&A activity during the first nine months of 2019, led by February’s BB&T’s acquisition of SunTrust Banks for $28.2 billion.

With the regulatory environment in the United States becoming more conducive to M&A, activity involving banks, credit unions, and other financial institutions is expected to remain strong.

Understanding M&A risks

Many small and midsized banks and credit unions in the nation are pondering deals as an opportunity to scale or grow, with the increasing M&A activity in the financial services sector. Yet, few have the in-house expertise to conduct the due diligence required to quickly understand and evaluate the risks within the lending portfolios of their target institutions. Such due diligence is instrumental, if financial institutions want to ensure they’re making the best deals given their current strategy and objectives and that they’re offering the right price for a given target. A lack of due diligence can lead to numerous surprises during the post-deal integration process, which can quickly erode deal value.

Working with a third-party advisor to conduct due diligence

As noted above. few banks and credit unions have the resources or expertise required to conduct deal due diligence. When working with a third-party advisor, financial institutions gain access to dedicated resources with a wealth of expertise by conducting similar due diligence activities and using proven processes and methodologies, which ensure that key risks are identified and quantified for inclusion in final deal pricing. For example, this might include penetrating, evaluating, and analyzing a target’s commercial portfolio or loan portfolio and then providing critical insights about any potential risks and opportunities such as high loan to value ratios, lack of current financial information used to risk rate loans and the lack of documentation included in appraisals to support credit decisions.

By conducting appropriate due diligence, financial institutions can ensure they’re making the right go or no-go decisions with respect to potential M&A deals, and that they have the information they need to structure any resulting deals in a manner that will reduce their post-acquisition risks and give the institution the greatest opportunity for return.

Managing your risks to create new opportunities

We’ve worked with numerous financial institutions to manage and evaluate credit risks both within their own organizations and as part of the due diligence process related to M&A deals. If you’d like more information on any of the issues highlighted in this article, please contact your local Plante Moran business advisor.