Wall Street’s Lucrative Leveraged-Debt Machine Is Breaking Down

(Bloomberg) — Probably the most lucrative money-making machines on this planet of finance is all clogged up, threatening a 12 months of pain for Wall Street banks and private-equity barons as a decade-long deal boom goes bust.

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After driving a flurry of mega buyouts that contributed to a $1 trillion profit haul in the nice times, a number of the world’s largest banks have been forced to take big writedowns on debt-fueled mergers and acquisitions underwritten late within the cheap-money era. Elon Musk’s chaotic takeover of Twitter Inc. is proving especially painful, saddling a Morgan Stanley-led cohort with around $4 billion in estimated paper losses, in accordance with industry experts and Bloomberg calculations.

The straightforward days aren’t coming back anytime soon for the fee-rich business of leveraged lending as a much-anticipated recession looms. Cue oncoming cuts to bonuses and jobs across the investment-banking industry as firms from Goldman Sachs Group Inc. to Credit Suisse Group AG contend with a slump in revenue.

Few have dodged the fallout. But Bank of America Corp., Barclays Plc and Morgan Stanley are amongst probably the most exposed to around $40 billion of dangerous loans and bonds still stuck on bank balance sheets — whose value has fallen dramatically as institutional buyers vanish.

“The dislocation is more pronounced and longer lasting than anything for the reason that Great Financial Crisis,” said Richard Zogheb, global head of debt capital markets at Citigroup Inc. “Investors haven’t any appetite for cyclical businesses.”

Probably the most sophisticated players, paid to know when the music stops, were doling out dangerous corporate loans at what now looks like ludicrously generous terms as recently as last April — effectively betting that the easy-money days would survive whilst inflation raged. Now the Federal Reserve’s resolve to tighten monetary policy on the fastest pace in the fashionable era has left them blindsided, cooling the M&A boom that’s enriched a generation of bankers and buyout executives over the past decade.Read More: Wall Street’s Top Stars Got Blindsided by 2022 Market Collapse

In an indication of how dangerous financing has all but dried up, an enormous private-equity firm was recently told by considered one of Wall Street’s biggest lenders that a $5 billion check for an LBO — no biggie within the halcyon days — would now be out of the query. It’s the same story from Recent York to London. Because the credit market slumps, bankers are either unwilling or unable to fireside up the high-risk-high-reward business of leveraged acquisitions.

Representatives for Bank of America, Barclays and Morgan Stanley declined to comment.“There’s no magic bullet,” said Grant Moyer, international head of leveraged finance at MUFG. “There’s $40 billion on the market. Certain deals will get cleared. But not every deal will clear the balance sheet in the primary quarter or the second quarter. It will be some time.”The freewheeling excesses of the low-rate years are not any more. In that era, leverage soared to the very best for the reason that global financial crisis, investor protections were stripped away, and ballooning debt burdens were masked by controversial accounting tricks to corporate earnings that downplayed leverage. Now as rates of interest jump and investors flee dangerous assets, financiers are having to adapt their playbook.

Bankers can take some comfort from the undeniable fact that projected losses on either side of the Atlantic are still modest compared with the 2008 bust when financial institutions were stuck with greater than $200 billion of this so-called hung debt. And the fixed-income market may yet thaw, allowing bankers to flog off more of their loans and bonds without realizing massive writedowns. But that’s an optimistic take. A more likely prospect: An industry-wide reckoning as leveraged-finance desks grapple with what some sober-minded bankers within the City of London call their “lists of pain” — underwater deals that include Apollo Global Management Inc.’s acquisitions of auto-parts maker Tenneco Inc. and telecom provider Brightspeed. When Wall Street lenders fully underwrite a financing, they’re on the hook to offer the money at agreed terms. When times are good, that’s not often an issue since banks can sell the debt to institutional investors who’re hungry for higher-yielding assets. Those commitments have helped grease the M&A machine because it reassures goal firms that transactions won’t fall through within the event the customer finds it difficult to lift the capital. In return, bankers earn handsome fees, often ranging between 2% and three.5% of the worth of the complete financing, and probably the most senior can pocket multi-million-dollar bonuses along the way in which.

Read More: Why Banks Face Billions in ‘Hung Debt’ as Deals CoolBut those days are over for now — a casualty of Fed Chair Jerome Powell’s mission to tighten financial conditions, curtailing speculative lending activities in its wake. While there have been a handful of M&A deals in recent months, these transactions have typically been underwritten on less-risky terms that pay modest fees as banks give attention to shifting the around $40 billion of debt they’ve been stuck with — a burden which will get greater. If and when regulators green light Standard General’s purchase of media company Tegna Inc., for instance, bankers risk being saddled with billions of dollars in debt that they agreed to offer for the deal before risk premiums spiked.

“We live within the constant knowledge that the leveraged financed market is cyclical, that markets turn, that acceptability of leverage changes over time and market appreciation of risk is continually shifting,” said Daniel Rudnicki Schlumberger, head of EMEA leveraged finance at JPMorgan Chase & Co.The debt hangover at a number of the world’s most systemically necessary lenders is tying up their limited capital to power latest LBOs, leaving the pipeline for deals at its weakest in years with soft echoes of the worldwide financial crisis. Because of this, leveraged-finance bankers are liable to receiving probably the most meager bonuses in possibly a decade, and a few banks will likely only reward their stars. Industry-wide layoffs might be steeper than for peers in other parts of the investment-banking business, in accordance with people accustomed to the matter, who aren’t authorized to talk publicly.“Last 12 months was a tricky one for leveraged finance,” said Alison Williams, senior analyst at Bloomberg Intelligence. “We expect 2023 to face the identical pressures, if no more acute.”The $12.5 billion of leveraged loans and bonds that backed Musk’s buyout of Twitter is by far the largest burden weighing on bank balance sheets for any single deal. A gaggle of seven lenders agreed to offer the money in April, when Russia’s invasion of Ukraine and rising rates of interest were already rocking global markets. By November, just a few weeks after the deal had closed, confidence in the corporate had eroded so rapidly that some funds were offering to purchase the loans for as little as 60 cents on the dollar — a price typically reserved for firms deemed in financial distress. That was before Musk said in his first address to the social media firm’s employees that bankruptcy was a possibility if it doesn’t start generating additional cash.

Bankers indicated that those offers were too low, and that they weren’t willing to sell the debt below a threshold of 70 cents on the dollar. Based on these kinds of levels — and even steeper discounts for the unsecured piece of the financing — estimated paper losses are around $4 billion, in accordance with the industry experts and Bloomberg calculations. Morgan Stanley, which wrote the largest check, would absorb about $1 billion, based on those self same estimates and calculations.

Twitter is difficult to value but lenders can have to account for the burden in some way even when the exposure isn’t singled out. And if Wall Street has any hope of selling the debt at less onerous discounts, they’d likely have to point out Musk is making good on his mission to bolster ad revenues and earnings.“Banks will err on the side of being conservative of their disclosures,” said veteran banking analyst Mike Mayo at Wells Fargo & Co. He believes that prior to the fourth-quarter earnings nearly to kick off, that “banks have likely taken half of the potential losses in drip and drabs to date on Twitter.”Representatives for the seven Twitter lenders declined to comment. A spokesperson for the social-media firm didn’t reply to requests for comment.

With debt commitments hard to come back by, the long-standing ties between Wall Street and personal equity shops, like KKR & Co. and Blackstone Inc., are liable to weakening. Banks have limited firepower and those that say they’re open for business are still offering terms that sponsors see as unattractive. So long as demand for leveraged loans and junk bonds stays weak, investment bankers will lose out on lucrative underwriting fees.

“We’re in a period of stagnation now where there hasn’t been plenty of latest net issuance in 2022 and there probably shouldn’t be going to be much in 2023,” said Schlumberger at JPMorgan. “It doesn’t suggest there won’t be activity, we predict a pick-up, but it’s going to be very much refinancing-driven.”

Given the upper cost of debt, buyout barons are finding it difficult to get latest deals done whilst asset valuations have fallen. Among the many handful which have cropped up, leverage is either sharply lower, or has disappeared entirely on the get-go — think leveraged buyouts without the leverage. Equity checks have gotten fatter, while some buyout attempts have fallen through. That points to potentially reduced returns for private-equity firms if debt stays elusive.“The hung debt can be an impediment to dealflow in the primary half, but offsets include opportunistic refinancing, loan-to-bond supply and base effects since we were down 80% last 12 months,” said Matthew Mish, head of credit strategy at UBS Group AG.

Banks have carved out more protection for themselves on some recent financing packages pitched to buyout firms, by requiring more flexibility to alter the worth at which debt will be sold inside a pre-agreed range. The bottom price of that band, a level at which banks would still have the option to avoid losses, has dropped to mid-80 to 90 cents on the dollar, in accordance with people accustomed to the matter, from as high as 97 cents before the market turmoil. In Europe, that floor has fallen to extremes within the low 80s, the people added, underscoring just how risk-averse banks have grow to be. Private equity sponsors have often been walking away from these offers.Even giants like Blackstone are struggling to clinch debt capital like the nice old days. For its purchase of a unit of Emerson Electric Co., the buyout specialist got less leverage that it could have done a 12 months ago, in accordance with individuals with knowledge of the matter. That’s even after tapping greater than 30 lenders, including private credit funds, to secure a number of the debt financing.

In other cases, direct lenders have managed to cough up the money. Meanwhile, KKR initially agreed to fund the acquisition of French insurance broker April Group entirely with equity, before eventually tapping financing from a combination of direct lenders and banks.

Some banks have been capable of chip away on the debt stuck on their balance sheets. In the ultimate weeks of 2022, a Bank of America-led group offloaded $359 million of loans for Nielsen Holdings, while other lenders have sold about $1.4 billion of Citrix loans via block trades at steep discounts. It’s the same story in Europe where lenders have managed to take care of the majority of the overhang, though a financing backing the buyout of Royal DSM’s engineering materials is looming. While the sales did cement losses for the banks involved, the move freed up much-needed capital.

More sales might be coming. Goldman has had discussions with investors about selling around $4 billion of subordinated debt that lenders backing the buyout of Citrix Systems Inc. have held for months. The timing is contingent on the discharge of latest audited Citrix financials, putting any potential trade heading in the right direction for late January or early February.

“It will be an enormous shot within the arm to get those positions moved,” said Cade Thompson, head of US debt capital markets at KKR, referring to Citrix and Nielsen debt. “Having said that, we don’t expect that the reduction of hung backlog alone will cause issuers to rush back into the syndicated market. A rally within the secondary can also be needed to be able to make a syndicated solution more viable.”Read More: Private Credit Funds Get Pickier as Downturn Fears Intensify

The underside line: the LBO machine is all jammed up, and because the Fed ramps up policy tightening it might take months to clear.

–With assistance from James Crombie, Bruce Douglas, Paula Seligson and Davide Scigliuzzo.

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