A $15 billion risky debt deal heralds day of reckoning for Wall Street

On paper, the deal was a no-brainer: a $15 billion debt financing that would net banks hefty fees and kick off a year of mega-acquisitions even as central banks tightened the spigots on their pandemic support.

Yet eight months after agreeing to finance the leveraged buyout of the workplace software company Citrix Systems, Wall Street is now staring at a very different picture. Banks are nursing more than $600 million of losses on bonds and loans they just sold to investors at a steep discount. And they're sitting on about $6.5 billion more Citrix debt that they'll be stuck with indefinitely.

David Paul Morris/Bloomberg

It may be just the beginning. After the biggest private-equity buyout boom in more than a decade, bankers still have to offload more than $50 billion in risky financing commitments, according to Deutsche Bank AG estimates. With central banks hiking interest rates to fight inflation and recession angst intensifying, few investors want to touch the debt without massive discounts, leaving the assets deeply underwater.

Major banks have already taken roughly $2 billion of writedowns this year. But those are now crystallizing into actual losses. The usually lucrative leveraged-finance business has all but dried up. Bonuses are being slashed. Job cuts may be next.

"This is painful," said Gustavo Schwed, a former partner at the private equity firm Providence Equity Partners who is now a professor at New York University Stern School of Business. "It's clear that inflation has persisted longer than a lot of people had imagined."

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Exactly how painful will depend on whether the U.S. economy slides into a prolonged recession and how quickly banks can offload the debt on their books, which is costly and constrains their ability to underwrite new deals.

Goldman Sachs Group — one of the lead arrangers of the Citrix buyout debt alongside Bank of America and Credit Suisse Group — plans to eliminate hundreds of jobs starting this month in its biggest cull since the start of the pandemic, an omen of tougher times ahead.

"Recessions have always led to reductions in force at investment banks because deal activity dries up and, aside from bonus reduction, they don't have a lot of ways to reduce their cost," said NYU's Schwed. "That may well happen again now."

Bankers who arrange debt deals for private equity firms know the drill. Leveraged lending has endured wild swings since it entered the mainstream in the 1980s: highly profitable during the good times and potentially explosive when risk appetite sours.

It was a soured loan to a highly leveraged mattress company in 1989 that forced Credit Suisse to bail out First Boston. And hundreds of billions of dollars of loans for leveraged buyouts spurred heavy losses for banks during the global financial crisis.

Deal drought

Dealmakers and debt bankers say a tough financing market and depressed valuations are putting a damper on new deals. Buyers and sellers are often far apart on valuations and boards are reluctant to entertain low-ball offers.

Global buyout activity is at its lowest since the third quarter of 2020, when the pandemic forced many private equity firms to pause new acquisitions, data compiled by Bloomberg show. The picture is even more dire across overall mergers and acquisitions, where third-quarter volumes are the lowest since 2012.

An executive at one of the biggest private equity firms said he's been focusing on longer-term opportunities because there's nothing to look at now. In some cases, firms are using more equity for acquisitions as they wait for debt markets to recover, one banker said.

More pain

While banks may be the first to feel the pain, the combination of high interest rates, slow growth and depressed valuations could also become a dangerous mix for private equity firms, given that most of the industry has never experienced such rampant inflation before.

"Private equity thrives on cheap debt," said Elisabeth de Fontenay, a professor at Duke University School of Law. "As the rates are going up that's going to slow down new deal activity significantly and it's also going to make the exits much harder."

Because many private equity deals are built on the assumption that the debt can be continuously refinanced, the industry might see "quite a few defaults" if rates continue to climb, de Fontenay said.

There are other big financings in the market. Banks are trying to sell about $3.9 billion of debt for Apollo Global Management's acquisition of some internet assets from Lumen Technologies. And two more deals are ahead: $8.35 billion of bonds and loans for the buyout of TV ratings company Nielsen Holdings by Elliott Investment Management and Brookfield Asset Management, and $5.4 billion for the auto parts firm Tenneco's buyout by Apollo.

NYU's Schwed, for one, still expects long-term profitability for the industry.

"Investment banks are very good at adapting," he said. "At some point the market will return to more favorable conditions and they'll continue to make a lot of money."

— With assistance from Michelle F. Davis, Michael Hytha and Paula Seligson.