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

by Clarence Jones

Moody’s Warns of Increasing Systemic Risks in Private Credit Sector

Credit rating agency Moody’s has raised concerns about a “race to the bottom” between banks and private credit funds in financing risky leveraged buyouts, a trend that it believes will heighten systemic risks across the US financial system. According to Moody’s, the renewed appetite among banks to lend on such deals and increased competition from the fast-growing private debt sector pose a threat as economic conditions deteriorate.

Moody’s analyst Christina Padgett, who leads the agency’s research of risky corporate lending, stated that large banks in the publicly syndicated loan market, which have lost substantial leveraged loan share to private credit rivals in recent years, will competitively enter the market as new leveraged buyouts emerge. This aggressive competition is expected to erode pricing, terms, and credit quality, thus fueling systemic risk.

The warning from one of the largest credit rating agencies in the US comes as the private equity sector slowly regains its footing following the Federal Reserve’s aggressive interest rate hikes last year, which created volatility in financial markets and significantly impacted dealmaking.

While buyout shops are once again seeking large transactions due to subsiding market volatility and concerns over an impending recession, banks are looking to regain their dominance in a business that has been largely taken over by the private credit industry. Additionally, private credit funds are increasingly offering services that were traditionally the domain of banks, such as providing revolving credit facilities to companies.

However, it is worth noting that private equity dealmaking remains sluggish and banks have been conservative in financing buyouts thus far. Many of Wall Street’s major banks have only recently started getting back into the market following a difficult period in 2022, during which they held loans tied to risky leveraged buyouts for companies like Citrix, Nielsen, Tenneco, and X (formerly known as Twitter). These banks collectively suffered significant losses before eventually selling the debt to other investors. Lenders to Elon Musk, who acquired X last year, have been unable to sell the debt linked to that deal.

Despite the slow start, banks’ appetite for financing leveraged buyouts has begun to rebound as prices in the loan market have recovered, and fund managers eagerly acquire low-rated corporate bonds and loans. This pricing rebound has been driven in part by a notable 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.

Moody’s analyst Christina Padgett warned that any race to the bottom in terms and pricing for leveraged buyouts carries broader systemic risk implications, especially in an environment where the economy is already weakening. She added that as private credit faces its first significant test in a higher interest rate environment, competition between lenders is likely to intensify.

To conclude, Moody’s warning highlights the potential risks posed by the competition between banks and private credit funds in financing risky leveraged buyouts. This heightened competition, coupled with deteriorating economic conditions, could erode pricing, terms, and credit quality, thereby increasing systemic risks across the US financial system.

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