Breakingviews: Banks’ LBO debt hangover may leave lasting scars

Leveraged-finance bankers are nursing a headache after one hell of a party. Bank of America, JPMorgan, Goldman Sachs, Morgan Stanley, Credit Suisse and Deutsche Bank collectively took about $1.5 billion of writedowns in the second quarter on loans they made to highly indebted companies. The hit adds to the case for job cuts.

Banks’ leveraged-finance desks make short-term loans to fund buyouts, typically for a 1% to 2% fee, which they sell on to investors like pension funds after a few months. The trouble starts when markets plunge before banks shift the risk, forcing them to write down the loans in anticipation of selling at a loss.

That happened this year, when rising rates and recession fears caused investors to shun risky debt. The average price of U.S high-yield bonds fell as much as 16% between January and early July, according to the ICE BofA U.S. High Yield Index. Problematic recent deals include the buyout of UK grocer Wm Morrison Supermarkets, backed by Goldman and others. If a court forces Elon Musk to buy Twitter, banks led by Morgan Stanley could take a hit when offloading the $13 billion financing. The $1.5 billion of writedowns taken at just six big banks is equivalent to more than half of the whole sector’s fees this year from arranging leveraged buyouts, using Dealogic data.

The good news is that markets are recovering. The same ICE BofA index, for example, has risen 7% since the end of June. That will make it easier for banks to sell down the $80 billion of loans that were stuck on their books as of late July, based on one senior banker’s estimate.

But the big picture still looks grim. With interest rates rising and the world heading for recession, it’s unlikely that banks will claw back all of the losses. Lenders behind the $15 billion debt package for the Citrix Systems buyout may end up keeping some of the debt for a while to avoid flooding the market, according to a person familiar with the deal. That chews up valuable capital.

Moreover, the buyout boom years, fuelled by cheap debt, may be over. Private equity investors like pension funds are cutting their exposure to the asset class at a record pace. And private lenders are displacing banks. Banks raked in $7.8 billion last year from arranging buyouts, which was 50% above the 2017 to 2019 average according to Dealogic. Likely lower fees in future, and the memory of this year’s losses, will make it hard for banks to justify keeping the same level of staff.

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BREAKINGVIEWS