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Moody’s warns of ‘systemic risk’ from leveraged lending market

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Credit rating agency Moody’s has warned of a “race to the bottom” between banks and private credit funds financing risky leveraged buyouts, a contest it believes will increase systemic risks across the US financial system.

The rating agency said on Thursday that a renewed appetite among banks to lend on such deals and greater competition from the fast-growing private debt sector risked funnelling more money to lower-quality deals, just as general economic conditions are deteriorating.

“We believe large banks in the publicly syndicated loan market — which have lost significant leveraged loan share to private credit rivals in recent years — will be competing aggressively as new leveraged buyouts emerge,” said Moody’s analyst Christina Padgett, who leads the agency’s research of risky corporate lending.

“This will cause pricing, terms and credit quality to erode, fuelling systemic risk.”

The warning from one of the largest US credit rating agencies comes as the private equity industry slowly begins to find its footing after the Federal Reserve last year aggressively hiked interest rates, rocking financial markets and dramatically denting dealmaking.

But buyout shops are once again hunting for elephant-sized transactions as volatility in markets and concerns over a looming recession have subsided. As a result, bankers and private credit executives told the Financial Times that in recent months they have fielded an uptick in calls to lend to the industry.

Many private equity firms had turned to the $1.5tn private credit industry to finance their deals over the past two years. These include Thoma Bravo, which used private lenders to help fund its $8bn purchase of business software provider Coupa Software, and Hellman & Friedman and Permira, which inked roughly $5bn in loans from creditors led by Blackstone to pay for their $10.2bn takeover of software maker Zendesk.

Banks, which have lost out on lucrative fees underwriting buyouts as a result, are hoping to muscle back in on a business they have long dominated. They are also facing greater competition as private credit funds increasingly offer services once squarely in banks’ purview, for instance providing revolving credit facilities to companies.

To be sure, private equity dealmaking remains sluggish and banks have so far been mostly conservative in the buyouts they have ultimately agreed to finance.

Many of Wall Street’s largest banks have only slowly started getting back into the market after a painful 2022, when they were stuck holding loans tied to risky leveraged buyouts for software maker Citrix, television ratings provider Nielsen, auto parts maker Tenneco and social media company X, formerly known as Twitter.

Lenders including Bank of America, Barclays, Credit Suisse and Goldman Sachs collectively lost billions of dollars as they eventually sold the debt on to other investors. Lenders to Elon Musk, who bought X last year, have so far been unable to sell the debt tied to that deal.

But their appetite has started to return as prices in the loan market have rebounded and fund managers eagerly buy up lowly rated corporate bonds and loans. That rebound in prices has in part been driven by a precipitous drop in loan issuance, with new high-yield bond sales — excluding refinancing activity — at their second-lowest annual level since the immediate aftermath of the 2008 financial crisis, according to data from LSEG.

Column chart of US high-yield bond issuance, excluding refinancings ($bn) showing Lack of new buyouts starves US high-yield market of deals

“Any ‘race to the bottom’ over LBO terms and pricing has broader systemic risk implications in an environment where the economy is already weakening,” Padgett added. “At the same time, a growing segment of the riskier leveraged loan market is being swept into private credit, beyond the purview of prudential regulators.”

She added: “Competition between lenders is likely to grow just as private credit faces its first real test in a sharply higher interest rate environment.”

Additional reporting by Harriet Clarfelt in London

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