One of the most lucrative money-making machines in the world of finance is all clogged up, threatening a year of pain for Wall Street banks and private-equity barons as a decade-long deal boom goes bust.
After driving a flurry of mega buyouts that contributed to a $1 trillion profit haul in the good times, some of the world’s largest banks have been forced to take big writedowns on debt-fueled mergers and acquisitions underwritten late in 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, according to industry experts and Bloomberg calculations.
The easy 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 among the most exposed to around $40 billion of risky 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 since the Great Financial Crisis,” said Richard Zogheb, global head of debt capital markets at Citigroup Inc. “Investors have no appetite for cyclical businesses.”
The most sophisticated players, paid to know when the music stops, were doling out risky corporate loans at what now looks like ludicrously generous terms as recently as last April — effectively betting that the easy-money days would live on even as inflation raged. Now the Federal Reserve’s resolve to tighten monetary policy at the fastest pace in the modern era has left them blindsided, cooling the M&A boom that’s enriched a generation of bankers and buyout executives over the past decade.
In a sign of how risky financing has all but dried up, a big private-equity firm was recently told by one of Wall Street’s biggest lenders that a $5 billion check for an LBO — no biggie in the halcyon days — would now be out of the question. It’s a similar story from New York to London. As the credit market slumps, bankers are either unwilling or unable to fire up the high-risk-high-reward business of leveraged acquisitions.
“There’s no magic bullet,” said Grant Moyer, international head of leveraged finance at MUFG. “There’s $40 billion out there. Certain deals will get cleared. But not every deal will clear the balance sheet in the first quarter or the second quarter. It’s going to be a while.”
The freewheeling excesses of the low-rate years are no more. In that era, leverage soared to the highest since the 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 interest rates jump and investors flee risky assets, financiers are having to adapt their playbook.
Bankers can take some comfort from the fact that projected losses on both sides of the Atlantic are still modest compared with the 2008 bust when financial institutions were stuck with more 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 in 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 provide the cash at agreed terms. When times are good, that’s not usually a problem since banks can sell the debt to institutional investors who are hungry for higher-yielding assets. Those commitments have helped grease the M&A machine since it reassures target companies that transactions won’t fall through in the event the buyer finds it difficult to raise the capital. In return, bankers earn handsome fees, often ranging between 2 percent and 3.5 percent of the value of the entire financing, and the most senior can pocket multi-million-dollar bonuses along the way.
But 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 focus on shifting the around $40 billion of debt they’ve been stuck with — a burden that may get bigger. If and when regulators green light Standard General’s purchase of media company Tegna Inc., for example, bankers risk being saddled with billions of dollars in debt that they agreed to provide for the deal before risk premiums spiked.
“We live in 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 constantly shifting,” said Daniel Rudnicki Schlumberger, head of EMEA leveraged finance at JPMorgan Chase & Co.
The debt hangover at some of the world’s most systemically important lenders is tying up their limited capital to power new LBOs, leaving the pipeline for deals at its weakest in years with soft echoes of the global financial crisis. As a result, leveraged-finance bankers are at risk of receiving the most meager bonuses in possibly a decade, and some banks will likely only reward their stars. Industry-wide layoffs could be steeper than for peers in other parts of the investment-banking business, according to people familiar with the matter, who aren’t authorized to speak publicly.
“Last year was a tough one for leveraged finance,” said Alison Williams, senior analyst at Bloomberg Intelligence. “We expect 2023 to face the same pressures, if not more acute.”
The $12.5 billion of leveraged loans and bonds that backed Musk’s buyout of Twitter is by far the biggest burden weighing on bank balance sheets for any single deal. A group of seven lenders agreed to provide the cash in April, when Russia’s invasion of Ukraine and rising interest rates were already rocking global markets. By November, just a couple of weeks after the deal had closed, confidence in the company had eroded so rapidly that some funds were offering to buy the loans for as little as 60 cents on the dollar — a price typically reserved for companies 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 more 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 types of levels — and even steeper discounts for the unsecured piece of the financing — estimated paper losses are around $4 billion, according to the industry experts and Bloomberg calculations. Morgan Stanley, which wrote the biggest check, would absorb about $1 billion, based on those same estimates and calculations.
Twitter is difficult to value but lenders will have to account for the burden somehow even if 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 show Musk is making good on his mission to bolster ad revenues and earnings.
“Banks will err on the side of being conservative in their disclosures,” said veteran banking analyst Mike Mayo at Wells Fargo & Co. He believes that prior to the fourth-quarter earnings just about to kick off, that “banks have likely taken half of the potential losses in drip and drabs so far on Twitter.”
Representatives for the seven Twitter lenders declined to comment. A spokesperson for the social-media firm didn’t respond to requests for comment.
With debt commitments hard to come by, the long-standing ties between Wall Street and private equity shops, like KKR & Co. and Blackstone Inc., are at risk of weakening. Banks have limited firepower and those who say they are open for business are still offering terms that sponsors see as unattractive. As 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 a lot of new net issuance in 2022 and there probably is not going to be much in 2023,” said Schlumberger at JPMorgan. “It doesn’t mean there won’t be activity, we are expecting a pick-up, but it will be very much refinancing-driven.”
Given the higher cost of debt, buyout barons are finding it challenging to get new deals done even as asset valuations have fallen. Among the handful that have cropped up, leverage is either sharply lower, or has disappeared entirely at 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 remains elusive.
“The hung debt will be an impediment to dealflow in the first half, but offsets include opportunistic refinancing, loan-to-bond supply and base effects since we were down 80 percent last year,” 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 change the price at which debt can be sold within a pre-agreed range. The lowest price of that band, a level at which banks would still be able to avoid losses, has dropped to mid-80 to 90 cents on the dollar, according to people familiar with the matter, from as high as 97 cents before the market turmoil. In Europe, that floor has fallen to extremes in the low 80s, the people added, underscoring just how risk-averse banks have become. Private equity sponsors have usually been walking away from these offers.
Even giants like Blackstone are struggling to clinch debt capital like the good old days. For its purchase of a unit of Emerson Electric Co., the buyout specialist got less leverage that it would have done a year ago, according to people with knowledge of the matter. That’s even after tapping more than 30 lenders, including private credit funds, to secure some of the debt financing.
In other cases, direct lenders have managed to cough up the cash. Meanwhile, KKR initially agreed to fund the purchase of French insurance broker April Group entirely with equity, before eventually tapping financing from a mix of direct lenders and banks.
Some banks have been able to chip away at the debt stuck on their balance sheets. In the final 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 a similar story in Europe where lenders have managed to deal with the bulk 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 could 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 release of new audited Citrix financials, putting any potential trade on track for late January or early February.
“It would be a big shot in the arm to get those positions moved,” said Cade Thompson, head of U.S. debt capital markets at KKR, referring to Citrix and Nielsen debt. “Having said that, we do not expect that the reduction of hung backlog alone will cause issuers to rush back into the syndicated market. A rally in the secondary is also needed in order to make a syndicated solution more viable.”
The bottom line: the LBO machine is all jammed up, and as the Fed ramps up policy tightening it may take months to clear.