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A participant bank supervised by the Office of the Comptroller of the Currency (OCC) filed a second-tier appeal to the OCC’s Ombudsman of the decision rendered by the interagency Shared National Credit (SNC) appeals panel during the first quarter 2019 interagency SNC review. The bank appealed the special mention ratings assigned to credit facilities related to the combination of two entities.
The appeal asserts that the obligor’s credit profile fits within the regulatory definition of a pass credit, with no potential weaknesses that pose elevated risk to prompt payment of principal and interest. The appeal contends that the base case projection indicates 60 percent debt amortization over a seven-year period and 49 percent achieved by year six. The appeal notes that the obligor’s year-end financial statements updated to reflect pro forma financials for the combined entity reflect a decreased pro forma leverage projection given the inclusion of day one and full run-rate synergies. The appeal advises that the base case includes projections of additional costs to achieve synergies and a simulated “cycle dip” in year two, and projects an increase in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) margins due to lower raw material costs and newly implemented price increases. The appeal also states that base case capital expenditures (CAPEX) projections are in line with historical CAPEX expenditures as a percentage of revenue, when normalized.
The Ombudsman conducted a comprehensive review of the information submitted by the bank and the SNC appeals panel, and relied on the supervisory standards outlined below:
The Ombudsman agreed with the SNC appeals panel that the credit facilities meet the supervisory standards of a special mention rating. The credit facilities exhibit potential weaknesses due to high execution risk in successfully achieving several assumptions to meet projected repayment capacity, i.e., the desired synergies, margin improvements, reduction in CAPEX, and accuracy of projected costs required to attain desired synergies. The appeal does not dispute the appeals panel’s conclusion that the borrower’s execution risk is elevated. The Ombudsman acknowledges that the bank’s base case scenario projects debt amortization of 60 percent over a seven-year period and 49 percent achieved by year six. However, the ability to amortize 50 percent or more of total debt over a five- to seven-year period is only one of several considerations in risk rating a credit. Refer to OCC Bulletin 2014-55. The Ombudsman also acknowledged that the base case scenario includes additional costs to achieve synergies and a simulated “cycle dip” in year two of seven years projected. However, the Ombudsman determined that the obligor’s ability to repay 60 percent of total debt over seven years and the projected reduction in leverage were dependent on assumptions regarding additional adjustments to EBITDA, including cumulative nonrecurring expenses, additional costs to achieve synergies, and cumulative synergies that represent 52 percent of cumulative free cash flow. Total debt to run-rate adjusted EBITDA, inclusive of the full projected run rate synergies, remains elevated and an elevated or high leverage level limits financial flexibility.
In addition, historical support for the deleveraging capability of the two combined entities is weak. The borrower’s recent operating trends, which include declining adjusted EBITDA margin levels that fall below base case projected margins, do not support an upgrade from special mention to pass without the combined company demonstrating its ability to achieve synergies, improve financial performance needed to support projected repayment capacity, and achieve projections.