Moody’s sees BSLs compete aggressively with private lenders for LBO opportunities

Fasten your seat belts: it could be a bumpy ride, as high interest rates meet the need to deploy dry powder.

A research note from Moody’s Investor Service predicts a deepening intensity of competition between broadly syndicated leveraged loans (BSL) on the one hand and private credit lenders on the other, through 2024.

This in turn could produce a number of negative consequences: the report expresses concern about an erosion of credit quality in a race to the bottom for the business, a higher default rate and greater systemic risks, in a chain of events that may begin with the revival of leveraged buyouts.

There has been a sharp decline in LBO activity over the past two years. That has left private lenders with considerable dry powder on their hands. Moody’s estimates the size of the powder barrel as close to $214 billion in the US and near $450 billion globally. The funds will use this barrel to compete aggressively for the task of financing the new mergers and takeovers as another wave gets underway.

One key difference between private fund lending and BSLs has long been the matter of scale. Yet there is an area of overlap in which borrowers can decide between the two, based perhaps on the cost of borrowing from either source, or the leniency of the covenants.

Another accepted difference between the two sources of lending is, precisely, the credit quality of those to whom they lend. Stronger credits access the syndicated loan market for cheaper pricing and more flexible documentation. Neither of these distinctions prevents competition between the two categories.

The LBO revival will play out in the context of higher interest rates. Even aside from competition for the loans and a possible race to the bottom, the new level of rates raises the obvious question of defaults. Moody’s has predicted that the US speculative grade default rate will be 4.6 percent in a year, above the long-term average of 4.1 percent.

Although it may be said that the 4.6 percent number is not apocalyptic – that rate went to 7 percent at the worst of the pandemic – the prospect of a race to the bottom among the contending lenders including private funds, BDCs and bank syndicates, is worrisome. Ana Arsov, the global co-head of banking with Moody’s Investors Service, observes that “large banks in the publicly syndicated loan market… have lost significant leveraged loan share to private credit rivals in recent years” and they will seek to regain the lost ground, “competing aggressively as new LBOs emerge”.

Another complication in this scene: as the report notes “purchase price negotiations for new LBOs have gotten more complicated as higher rates, inflation and an economic slowdown have pressured sellers to modify their price expectations”.