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Moody’s warns of heightened systemic risk in US leveraged lending market

Renewed competition between US banks and private credit firms to finance leveraged buyouts (LBOs) will erode credit quality and fuel systemic risks, a report by ratings agency Moody’s Investors Service says.

After spending most of 2023 on the sidelines, banks’ underwriting and sales of new LBOs on behalf of speculative-grade borrowers surged in September. From the end of last week, banks so far this month had sold $18.3bn in junk-rated bonds, which included several LBOs, according to IFR data.

Moody’s analysts in the report said the increase in leveraged buyouts is driving greater competition for funds between banks and the opaque, less-regulated private credit firms.

“New sources of risk are on the rise as major lenders jockey for greater capital clout and returns,” the report noted.

“As public and private lenders compete over pricing and terms, credit quality will erode, increasing defaults,” it added.

Moody’s forecast the US speculative grade default rate will be 4.6% in a year versus 4.7% now and 1.5% a year ago.

Direct lenders and other alternative asset managers are now turning to individual investors and their $125-trillion to $150-trillion in assets to fill the gap left by institutional investors, according to Moody’s.

Many are doing this by raising evergreen or open-ended funds, the report said. While investors could withdraw committed capital at a set date, the rise in evergreen funds allows them to withdraw a certain percentage at any point in time, the report said.

If too many investors do so, this raises the risk of asset managers running short on liquidity if and when they need it, according to Moody's.

Such was the case last year, when investors scrambled en masse to withdraw their funds from Blackstone’s real estate fund, BREIT, on dimmed prospects for the commercial real estate market, the report said.

“So when you think of liquidity risk, as a market deteriorates, liquidity leaves,” Christina Padgett, Moody’s head of leveraged finance and the report's lead author, said.

“That is much more true if you have retail investors than if you’re relying on your insurance company, for example,” she said.

The introduction of this volatility to the already-risky private credit market, combined with rising leverage among companies already highly indebted, presents broader risks to the US economy, according to Padgett. “Those are new risks.”