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The International Organization of Securities Commissions, or IOSCO, has published a Consultation report on best practices to consider regarding leveraged loans and CLOs.
In an environment of low default rates, the leveraged loan (“LL”) and collateralized loan obligation (“CLO”) markets have evolved significantly since the Great Financial Crisis, both in terms of growth and basic terms of borrowers and investors. This growth and the shift in market participants from banks to non-banks has led IOSCO to focus on what it sees as an increase in covenant-light LLs, using “overly optimistic” EBITDA adjustments in increasingly complex documentation which could potentially work to the detriment of LL. investors. After extensive dialogue with market participants, credit rating agencies and other professionals on the impact of fewer and more flexible clauses on investor protection, the adequacy of current transparency standards in LL markets and CLO and other conduct issues, IOSCO presents 12 suggested best practices. grouped into five themes covering the intermediation chain from the origination of LL to the sale of CLO.
IOSCO Best Practices
Theme A – origination and refinancing based on sound commercial principles:
- Measure 1 – debt repayment capacity test: this must be supported by sound business and financial risk assumptions and borrowers must be able to demonstrate sufficient debt repayment capacity (ability to repay 100% of senior debt or 50% of total medium-term debt).
- Measure 2 – Dividend Recap: Dividend recapitalizations should be considered based on remaining equity support, leverage and debt repayment capacity, and reliance on additional debt should be limited.
- Measure 3 – Enterprise Values (“EVs”): EVs should be based on “well-constructed” financial models with disclosure of key assumptions and independent review and validation.
Theme B – Transparency of EBITDA and loan documentation:
- Measure 4 – EBITDA Complexity and Transparency: EBITDA definitions should not be unnecessarily complex and adjustments should be made on a reasonable and justified basis.
- Measure 5 – Transparency on Covenant Limitations: Clear, concise and effective covenant documentation with full disclosure of key terms that could have a significant impact on a borrower’s credit risk.
Theme C – strengthening the alignment of interests from the granting of the loan to the final investors:
- Measure 6 – transparency and fairness during subscription and syndication: sufficient and clear information to enable informed investment decisions.
- Measure 7 – alignment of interests between underwriting entities and investors: whether through risk retention or other means. LL underwriting entities and investors are “encouraged to obtain independent and impartial legal advice that represents their interests.”
Theme D – responding to the interests of different market players throughout the intermediation chain:
- Measure 8 – reduce restrictions on loan transferability: broad transferability and transparency of any restrictions are encouraged.
- Measure 9 – manage conflicts of interest when EP sponsors also act as lenders: Conflict management and disclosure is essential here.
- Measure 10 – management of conflicts of interest in the management of CLOs: emphasis is placed on the use of trust indentures and providing sufficient opportunities to conduct due diligence on valuation methodologies and results , alongside the identification and management of conflicts.
Theme E – continuous disclosure of information:
- Measure 11 – Disclosure in CLOs: Regular provision of all materially relevant information on the valuation, credit quality and performance of the CLO portfolio must be carried out in accordance with local regulatory requirements.
- Measure 12 – disclosure of underlying loans: it must be timely, up to date and include all events that could invalidate the assumptions or impacts.
The IOSCO draft best practices are intended for “review by market participants” and do not constitute standards or recommendations. Responses to the consultation and the questions it raises are expected by December 15, 2023.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your specific situation.
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