Why should private equity behave prudently when no one else will? Issuers, many of them buyout businesses, have sold more than $500bn of leveraged loans in the US so far this year, already a single-year record. The largest buyers of these risky loans are funds that slice and dice them into “collateralised loan obligations”. Collateralised debt obligations, which often layered residential mortgages in a similar way, were instrumental in the financial crisis.
Banks and insurers have become increasingly aggressive buyers of corporate loan products. This has helped private equity groups launch a slew of buyouts and “dividend recapitalisations” — which take cash out of businesses they already own.
Buyout specialists would riposte that corporate loans are theoretically much safer than mortgages, thanks to their corporate nature and seniority, within capital structures. Still, with prices soaring and yields dropping, it is clear that investors have lost their discipline.
The biggest loan sale of the year has been a $7bn issue by Medline Industries, a medical products business acquired by Blackstone, Carlyle and Hellman & Friedman in a $34bn takeover. The loans yield a skinny 4 per cent — though if interbank rates rise sharply, interest payments will jump too. When the loans hit the market in September, they immediately began trading above par, according to data from S&P LCD, a sign of ebullience.
Investors have meanwhile put aside scruples concerning the debt-financed dividends some private equity groups use to take money off the table before a company sale. Loan proceeds for dividends in 2021 have risen 84 per cent versus 2018.
Banks and insurers have upped their allocation of funds to CLOs by at least 20 per cent in recent months according to research from Bank of America and an insurance regulator, cited by S&P.
The default rate among companies that have issued leveraged loans is essentially zero at the moment. But a bumpy shift to a world with higher interest rates would leave many companies struggling. Habitual opprobrium would be heaped on private equity owners. Investors on the other side of that trade should have just as many questions to answer.
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