This is the epicentre of the next financial blow-up
Most leading bankers agree that the massive and risky US leveraged loan market will be the epicentre of the next financial blow-up
If there’s one thing senior bankers can agree upon, it’s that the next blow-up in global financial markets will be centred on the massive US leveraged loan market. It’s not surprising that bankers are concerned, given that a staggering $US350 billion ($554 billion) of low-cost loans taken out by highly geared companies have to be refinanced in the next three years. But these companies now find themselves in a bind. Their revenues are coming under pressure as a slowing US economy dents their sales and squeezes their profit margins. At the same time, the steep rise in US interest rates since early 2022 means these companies are about to be hammered by a huge rise in borrowing costs on their massive debts. Some highly leveraged companies will be able to call on their investors – particularly if these are private equity sponsors – for extra equity which they can use to whittle down their debt burdens. But there will be limits to the extent to which private equity firms will be willing to bail out troubled portfolio companies. Many investors will be reluctant to see their money being used to rescue companies that are over-leveraged and underperforming, particularly if their fund is reaching the end of its life. At the same time, many large US banks have been stung by the heavy losses they’ve suffered from offloading the leveraged loans they agreed to underwrite before the era of cheap money came to a screaming halt last year. For instance, the group of Wall Street investment banks – including Goldman Sachs and Bank of America – that stitched together the financing for Elliott Management and Vista Equity Partners’ $US16.5 billion buyout of cloud computing company Citrix, were left nursing more than $US1 billion in losses when they sold the debt to investors at a steep discount. Meanwhile, the group of banks, led by Morgan Stanley, that provided some $US13 billion in bank debt as part of Elon Musk’s $US44 billion takeover of Twitter (now officially rebranded as X), have opted to park the loans on their balance sheet to avoid selling at a hefty loss.With banks becoming more wary, highly leveraged companies are increasingly turning to the $US1.5 trillion private credit industry for the fresh funding they desperately need to avoid default and messy bankruptcies. Private credit funds have been steadily expanding in the US corporate lending market since the 2008-09 financial crisis curbed banks’ appetite for risk. Some of the big players – including Apollo Global Management, Ares Management, Blackstone and KKR – started out in private equity or as alternative asset managers before moving into private credit. Others – including Blue Owl Capital, HPS Investment Partners and Sixth Street Partners – were set up specifically to provide private debt.“We are in the beginning of a secular shift in how credit is provided to businesses, and a shift that I believe will continue to gather speed,” Apollo chief executive Marc Rowan told analysts in August. These firms typically raise money from superannuation funds, insurers and wealthy individuals, who are attracted by the high returns on offer. Over the past decade, private lenders delivered average returns of 9 per cent, well above the miserably low yields offered by most debt investments. In addition, private credit providers are increasingly forging alliances with insurance companies that are sitting on hundreds of billions of dollars they need to invest in investment-grade debt. Tough covenants Not surprisingly, interest rates on private loans are expensive – often private credit loans charge a margin of 5 to 7 percentage points above benchmark interest rates, compared with 4 to 4.5 percentage points for bank loans. And they frequently impose tougher loan covenants, prohibiting borrowers from selling assets or raising additional debt. All the same, for many highly geared companies they represent a financial lifeline. But some bankers worry that the rise of private credit industry has shifted a huge amount of financial power into the hands of a few large, opaque asset managers who lie outside the view of prudential regulators. And they point to a worrying trend whereby companies are borrowing from private credit firms to repay their bank loans. For instance, the US financial software firm Finastra raised $US4.8 billion – the largest private credit loan on record – from Blue Owl, Oak Hill Advisors and others to refinance a loan arranged by Morgan Stanley. This means the big US banks, which are seeing their loan underwriting fees dwindle, are watching the exponential growth of private credit firms with some alarm. And now that they’ve managed to shift tens of billions of dollars of leveraged buyout debt off their balance sheet – often selling the loans to private credit providers at steep discounts – the big US banks are looking to reassert their erstwhile dominance in the leveraged loan market. This renewal of competition offers some hope for debt-laden companies. For instance, the KKR-owned PetVet is holding talks with private credit funds as it looks to refinance more than $US3 billion in loans. But the US veterinary hospital operator has also indicated it is open to the possibility of bank loans. But it has rung alarm bells for credit ratings agency Moody’s which last month said that US banks’ renewed interest in financing leveraged buyouts could push them into a “race to the bottom” with private credit funds. Moody’s warned that large banks will likely compete aggressively with private credit rivals to claw back the market share they’ve lost in the leveraged buyout market, and this could result in an erosion in pricing, terms and credit quality. All the same, the memory of recent losses means that the big US banks have been relatively cautious in agreeing to fund new buyouts. And they’ll undoubtedly become even more cautious as soon as there’s a spate of defaults on large leveraged loans.
What we don’t know is how private credit industry will react when they face the litmus test of souring loans.
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