Turmoil in the Capital Markets Industry

Article by Oscar Luck

On Thursday, the 22nd of June, the Bank of England decided to raise interest rates by 0.5% to 5% with the intent of increasing the cost of capital to decrease expenditure. Millions are left dreading this change as flexible-rate mortgage payments that were already extortionate become unaffordable. Individuals, however, are not the only parties affected by altering loan repayments due to the higher repo rate, as a variety of businesses are facing negative cash flows, and Private Credit Funds are facing increased default rates – their first major challenge since their popularisation after the 2008 crisis.

Leveraged Buyout Remains

During the COVID pandemic, especially in 2021, Private Credit Funds provided capital for numerous leveraged buyouts based on the assumption of ambitious projections of future profit, with the global buyout deal value reaching a record high in nearly all markets, totalling around $900bn. These loans were executed under the extremely favourable market conditions of 2020-2021, with negligible interest rates and stable inflation, causing many companies to accept the use of flexible interest rate agreements indexed to the base rate of interest either from the BoE or from an alternative source. These Leveraged Buyouts are primarily used by Private Equity Firms and other investors to acquire a majority interest in their target company. However, due to the structuring of Leveraged Buyouts, it is unlikely that loans represent an expense for the holding firm itself, as debt is normally attributed to the acquired company to be paid off through cash flows.

These loans, however, are often tied to inflation, causing any overly ambitious buyout loan to pose potentially disastrous consequences if cash flows are insufficient. An exemplar of this is Thames Water, having been acquired in 2006 by Macquire, which piled £15.9 billion of debt through its buyout onto the company. Half of this debt is interest rate variable, causing the strain on the company, which already holds substantial debt-to-equity ratios to increase substantially, with many now fearing the subsequent collapse and necessary nationalisation of the water company.

This is not solely problematic for Thames Water and other previous target companies, as the inability to pay back loans results in default to the lenders. This effect has been clearly identified by Moody’s, who issued a public warning about the possibility of private lenders, specifically Ares and Owl Rock private credit funds, who are claimed to be falling into financial difficulties as loan repayments are unmet.

Bank Immunity

Unfortunately, large banks are not impervious to credit default either, as US regional banks have begun selling off their consumer loans predominantly to private credit firms and hedge funds at a discount rate as funding them becomes more difficult, attempting to clear their balance sheets and cut their capital requirements as finances are squeezed. For example, Ares Management Corp, referenced earlier as already vulnerable to consumer default, has recently bought a $3.5 billion loan portfolio at a discount from PacWest Bancorp. This trend has caused the yield on asset-backed securities to reach their highest level since the financial crisis. Therefore, banks are sacrificing potential profits by offering discounted loan rates to maintain capital requirements and not reach excessive illiquidity levels.

Consumer credit default has been felt across the world, especially in relation to Swedish real estate, where a primary mortgage lender SBB has had their credit rating downgraded from BB+ to BBB- as lenders cannot afford their monthly repayment. This is correlated with a decrease in their share price and their decision to postpone a share offering until market conditions and perceptions are more favourable.

Libor

Higher interest rates are not the only source of turmoil in capital markets, however, as the long-expected closure of the LIBOR lending benchmark has recently finalised on June 30th. This is problematic for debt holders, with many less than a month ago having more than $1.4 billion still tied to the market rate, with a few being unable to reach an agreement as to an alternate rate to use now that their contracted rate is prohibited. This signals a substantial change in the capital market industry as the former scandal-ridden benchmark occupied a substantial market share, and it will take a long time to adjust entirely to the changes. Libor does, however, seem to have a successor in the SOFT, the secured overnight financing rate, which will operate in a similar fashion instead measured against treasury securities. These rates are important as they are normally used as the default interest rate between firms rather than any government repo rate. This reduces the requirement for continual negotiation between parties over which rate to use in smaller transactions.

Impact on Law firms and Businesses

All these factors suggest that capital markets practitioners are likely to see an uptake in their workload, as although debt issuings will be decreased, especially in the realm of leveraged buyouts, many businesses are requiring their debt to be restructured. Many banks are in the process of having to sell off their debt through various means. Simultaneously, however, it is likely to decrease demand for private equity transactions and project finance deals as ordinary asset classes such as bonds offer high yield with minimal risk, capable of maintaining value through high inflation. Any potential project to be taken on would thus be required to pass a higher hurdle rate before being considered viable and profitable, decreasing demand significantly.