Moody’s Credit Rating Agency has warned against a “race to bottom” among banks and private funds that finance leveraged buyouts with high risk. It believes this will increase systemic financial risks in the US.
Rating agency warned on Thursday of a risk that the deterioration in economic conditions could lead to a greater influx of money into lower-quality debt deals due to heightened competition among banks.
As leveraged buyouts become more common, we expect large banks to compete aggressively in the publicly syndicated loans market. They have been losing significant share of the leveraged loan market in recent years.
This will lead to an erosion of credit terms, pricing and quality, thereby increasing systemic risk.
The warning comes from one of the biggest US credit rating agencies as the private equity sector slowly begins to find their footing following the Federal Reserve’s aggressive interest rate hikes last year, which rocked financial markets and severely impacted dealmaking.
As the market volatility and fears of a recession recede, buyout shops have begun to look for large transactions. In recent months, private credit executives and bankers have received more requests to lend money to the industry.
In the last two years, many private equity firms have turned to the $1.5tn industry of private credit to fund their deals. Thoma Bravo used private creditors to fund its $8bn acquisition of business software provider Coupa Software. Hellman & Friedman, Permira and Blackstone also received loans of around $5bn from creditor led by Blackstone for their $100.2bn acquisition software maker Zendesk.
The banks, who have been deprived of lucrative fees for underwriting buyouts, want to regain control over a market they’ve long dominated. Private credit funds are increasingly offering services that were once the sole domain of banks, such as revolving credits to businesses.
Private equity dealmaking is still sluggish, and banks are being conservative with the buyouts that they agree to finance.
After a difficult 2022 in which they were forced to hold loans tied to leveraged buyouts of software maker Citrix and television ratings provider Nielsen as well as auto parts manufacturer Tenneco, many Wall Street banks are slowly returning to the market.
Bank of America and Barclays lost billions of dollars when they sold the debt to other investors. Lenders of Elon Musk who purchased X last summer have not been able to sell debt related to the deal.
Fund managers are eager to buy corporate bonds and low-rated loans as the prices on the loan market rebound. This rebound in prices is partly due to a sharp drop in the loan market. According to LSEG data, new high-yield bonds sales, excluding refinancing, are at their lowest level annually since the immediate aftermath 2008 financial crisis. Padgett said that “any ‘race to lower’ LBO terms and prices has wider systemic risks in an economy where it is already weakening.” “At the time, a segment of the more risky leveraged loan market, which is outside the purview prudential regulators, is being swept up into private credit.”
She said: “Competition among lenders will likely grow at the same time that private credit is facing its first real test under a dramatically higher interest rate environment.”