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Financial engineers are having a tough time finding lubricant.

By Dan Primack
November 3, 2014

The biggest story in private equity right now isn’t about the deals getting gone. It’s about the ones that aren’t.

At issue is an evaporation of leveraged loans, the bank-arranged debt that enables private equity firms to goose returns and minimize risk. For example, Thoma Bravo’s recent deal for Compuware CPWR includes just $675 million from Thoma Bravo, and more than $2 billion in debt committed by Jefferies JEF , Credit Suisse CS and Deutsche Bank DB . Less risk, more reward.

Leveraged loans always ebb and flow with the broader bond markets, so it shouldn’t be too surprising that recent high-yield volatility (sparked, in part, by Bill Gross’s exit from Pimco) has caused some new issuance pullback. What has exacerbated the situation this time around, however, is Federal Reserve pressure on banks to keep leveraged loan multiples at less than 6x a target company’s EBITDA. Not so much because the Fed is actually worried about banks taking on too much risk — typically they only act as middlemen, with the actual loans held by all sorts of third parties — but because it is worried more broadly about an overleveraged capital market, and banks are their only purview. Consider it a backdoor way to regulate hedge funds, mutual funds, CLOs, insurance companies and, of course, private equity.

Under normal conditions, a 6x ceiling wouldn’t be too problematic for private equity. But this is 2014, where the only thing higher than a company’s stock price is where that company’s board believed the stock price will be in a year. Private equity firms must pay extra premiums to create sale opportunities, while also securing high leveraged loan multiples so as not to reduce their own return expectations. That’s why nearly half of all leveraged buyouts this year have included debt multiples above 6x EBITDA (the highest such levels since 2007) and, in turn, why the recent Fed action has chilled new deal activity.

“We had term sheets last Friday from six banks on a new deal,” a senior private equity executive recently told me. “All around the same price, all above 6x. Then, on Monday, all but one of them got cold feet. They didn’t say explicitly that it was because of the Fed, but we all know it was. Same thing is happening to lots of other deals.”

It is unlikely that we’ll see the results of this phenomenon in Q4 deal data, as many of today’s leveraged buyouts were structured months before the Fed began making waves. But the current pipeline is virtually empty, meaning that the deal cliff should become apparent in Q1 2015.

What we will see in the interim, however, is banks having a tough time syndicating the handful of high-priced deals that did get signed since Labor Day. And, rather than simply underwriting the notes and waiting for them to find buyers at par, the banks will take upfront losses and move on. For example, there was a report last week that Jefferies is facing up to a $15 million loss related to debt on Bain Capital’s purchase of a 50% stake in Toms Shoes.

“Underwriters lose real money when we get a market correction when there are lots of deals in the pipeline, which we don’t have right now,” says a different private equity executive.

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