IOSCO opens leveraged finance consultation

The consultation by the International Organisation of Securities Commissions (IOSCO) comes amidst closer scrutiny of private equity-sponsored leveraged buy-outs (LBOs) in Europe and the associated risks where ‘designated counsel’ is practised – whereby the private equity (PE) sponsor selects a law firm to act on behalf of the underwriters or lenders, sometimes even before the lenders themselves are selected. The fees for the underwriters or lenders’ legal advice will customarily be met by the PE sponsor in addition to their own legal counsel’s fees.

In a new consultation paper it has issued (60-page / 703KB PDF), in which it has proposed ‘good practices’ in respect of leveraged loans (LLs) and collateralised loan obligations (CLOs), IOSCO said that the justification for the designated counsel approach is that it “allows the PE sponsor to rely on law firms that are familiar with their LL structure and documentation, thereby facilitating a faster and smoother syndication”. However, it also recognised that there are concerns within industry about the practice.

Specifically, IOSCO said the industry had highlighted to it that the practice of designated counsel “limits their choice of legal counsel and may not serve to ensure that the advice they receive is independent”, and further raised concern that it can give rise to conflicts of interest “whereby lawyers representing the banks might be reluctant to push back against sponsor lawyers due to the risk they could be excluded from the market for lender-side work”. It added that some lenders have been appointing their own ‘shadow’ legal counsel alongside the counsel designated by the sponsor in recent months.

In response, IOSCO has advocated independent legal advice as a proposed good practice, though stops short of recommending an end to the practice of designated lender counsel.

“Underwriting entities and LL investors are encouraged to obtain independent and impartial legal advice which represents their interests and strengthens their ability to negotiate loan terms on individual transactions and to influence the overall evolution of the market, both on documentation and processes,” IOSCO said. “In doing so, they will be in a better position to shape the risks they could be exposed to in the event of failed syndications or a market downturn, and also strengthen their alignment of interest with the ultimate LL investors who will be exposed to the credit risk of the loans for the long term.”

Leveraged loans are a debt financing tool that is at the heart of LBOs, though they are also increasingly popular with businesses. They are commonly used to raise funds to complete mergers or acquisitions, or to undertake refinancings or other corporate balance sheet recapitalisations. The loans granted are secured against the borrower’s assets, and in the case of LBOs and other corporate acquisitions, the target group’s assets too. Some leveraged loans are underwritten by banks, potentially with a view to syndicating the debt to other financial institutions or LBO investors, but increasingly the funds are being provided directly to the PE sponsor’s investment vehicle or the borrower by private credit and alternative capital providers. CLOs arise where a portfolio of leveraged loan assets are bought and the portfolio is financed through the issuance of bonds.

Max Millington, a specialist in leveraged finance at Pinsent Masons, said: “The practice of designated lender counsel within leveraged finance has been on the radar of European market participants for decades, but it is in the last year or so that it has really been under the microscope. What is perhaps different now – and the consultation alludes to this when it speaks about the growth in recent direct lending shadow counsel instructions – is that whereas previously the designation practice centred upon upper-mid to large capitalisation, originate-to-distribute syndication markets, more recent application has been to mid-market, take-and-hold investments.”

“For the former category of transaction, designated lender’s counsel’s role is, arguably, more congruent with facilitating syndication by underwriters to LBO investors; in the latter scenario, investors originating the transaction will naturally be more focussed on the adequacy of the documentary controls underpinning the specific credit and will consequently have a closer interest in robust representation from a smaller group of trusted legal advisers,” he said.

“Market evolution has meant the private debt community has been at the heart of such a drive for independent counsel and closer scrutiny of the use of sponsor precedent documentation. However, we have also observed that corporate banks and their affiliated entities operating in this space, who are significantly less likely than their investment bank counterparts to syndicate, have also recently taken a greater interest. Financial institutions of all kinds will therefore no doubt wish to contribute to the consultation – as indeed may the private equity industry and the legal profession,” Millington said.

The IOSCO consultation – which covers many areas of potential interest to market participants in addition to that of designated lender counsel – is open to feedback until 15 December.