This week we chat with Tess Virmani, SVP and Associate General Counsel of the Loan Syndications and Trading Association (LSTA). Tess works with the LSTA’s Primary Market Committee and Trade Practices and Forms Committee on legal projects. She also works on advocacy and regulatory matters.

The Lead Left: Tess, thanks for joining us. I saw your excellent presentation at the Middle Market Symposium last week, and thought it would be great to pass along to our readers [link]. We have seen bank activity be impacted by the Leveraged Lending Guidance. I guess there are some reasons for banks to be optimistic about the new regulatory environment.

Tess Virmani: Yes, Randy, there is. The new administration will have the opportunity to appoint new heads at all three banking regulators. One would imagine that any appointee will share the administration’s concern for burdensome regulation. Although some of what direct lenders are bringing to the table is not just a product of Leveraged Lending Guidance, but rather speed of execution. As a borrower you may be willing to paying more for certainty and speed. There may still be opportunities for direct lenders if banks get a bit more of a relaxed environment, especially if direct lenders’ balance sheets continue to grow. But if regulatory change happens for the banks, it will certainly open up more of the market for them. And I would suspect we might see the share of large cap bank leveraged lending improve.

TLL: For the benefit of our readers, how long has Leveraged Lending Guidance been around?

TV: The Guidance was first released in 2013, then clarified with a list of Frequently Asked Questions that came out in 2014. So we’ve been living in this regulatory environment for about four years.

TLL: With the benefit of time, what kind of lessons have you learned about this regulation?

TV: There are two lessons learned. First, the Guidance is applied very much like a rule. While there are a number of guiding principles found in the Guidance, the most important seems to be demonstrating the ability of the borrower to repay its debt within a five to seven year period. Yes, leverage over six times ebitda is a concern, but for a “pass” credit the agencies are putting a lot of focus on cash flow.

Second, I would say that regulators have become well-versed in some of the flexibility that has been introduced into loan structures in recent years. Initially, they highlighted “weak underwriting” and “lack of maintenance covenants” but now we also see focus on “add-backs” and “baskets” in the credit agreement itself – the things banks live with every day. Regulators now appreciate these nuances and seem more focused there. There’s a push to look at credit at a holistic level – not just the size of the capital structure when the deal is first put together, but to focus on what could happen to it.

TLL: Are you seeing signs of deterioration? The stats show leverage topping out, but has it?