The Goldman Sachs bankers were in a hole.

It was February 2022 and they were trying to sell over £5bn worth of bonds and loans backing the UK’s biggest leveraged buyout in years: US private equity firm Clayton, Dubilier & Rice’s £10bn takeover of grocer Morrisons.

They were well behind schedule, having put plans on hold before Christmas when the fast spread of the Omicron coronavirus variant made investors jittery. But now the economic outlook was darkening and markets were cooling.

Still, Goldman had a plan. Its bankers had just sold the riskiest £1.2bn slice of the debt behind closed doors and were planning to launch the syndication process for the remainder at the end of the month. They even believed they might avoid taking a loss on the deal.

Then Russian tanks crossed the border into Ukraine.

The war set off an economic shock that would turn the Morrisons mega-deal from a dream ticket for the bankers into a nightmare. The supermarket buyout has cost banks that underwrote the deal hundreds of millions of pounds and now symbolises the excesses of the cheap-money era.

“It’s the biggest fiasco since the Boots LBO,” said one loan fund manager, referring to the 2007 leveraged buyout of the British pharmacy chain that left banks holding billions of pounds of debt as credit markets turned.

In LBOs, banks initially underwrite the debt and then sell it on to specialist funds. This means the underwriters can end up booking losses if investors demand higher yields than initially expected. If a deal really struggles, it can end up “hung”, forcing banks to hold the risky debt on their own balance sheets.

In an era of abundant liquidity, very few deals went wrong and bankers grew more complacent about the risks. As competition intensified, they left themselves ever smaller margins of safety.

Now, as central banks raise interest rates in a bid to tame inflation, banks are struggling to sell deals they signed before the market turned. Many are suffering large losses in the process.

But among the mass of European deals that could turn sour, the hit the banks could take on the Morrisons debacle puts it in a league of its own.

The group of 16 underwriters have already taken an over £200mn gross loss on selling the debt this year, according to Financial Times calculations. Marking the remaining unsold debt to market leaves a further £400mn hole.

A warning from history

When leverage is piled on top of a business with thin margins and large fixed costs, there is potential for disaster.

In 1989, at the peak of the first LBO boom, the investment firm Isosceles took over supermarket group Gateway — later renamed Somerfield — in a multibillion pound deal that soured almost immediately, as market exuberance gave way to recession.

But 30 years later, memories of the debacle had faded. With private equity cresting a wave of cheap money, the blockbuster grocery buyout was back.

First, TDR Capital and the billionaire Issa brothers bought Asda for £6.8bn in 2020. Red-hot junk bond markets allowed the buyers to only put up a thin sliver of their own money to complete the transaction, reawakening buyout bosses to how lucrative these deals could be.

Months later, CD&R made its move on Asda’s rival Morrisons.

In a nation of shopkeepers, a US private equity firm descending on a cherished grocer caused a stir. Morrisons had been a publicly traded company since the 1960s, listing a few years after Sir Ken Morrison transformed his father’s Bradford market stalls into a fully fledged supermarkets business.

In the decades that followed Morrisons grew into one of the UK’s largest supermarket chains, acquiring Safeway in 2004, and expanding well beyond its northern England heartland.

CD&R had a knight of the realm onboard to smooth its Morrisons takeover: Sir Terry Leahy, the former Tesco chief, was a longtime adviser to the US firm. And while Morrisons’ management fiercely guarded its independence, its share price had languished for years, making a sufficiently high bid hard to resist.

In City parlance, Morrisons was now “in play”. After the retailer rebuffed CD&R’s £8.7bn approach in June 2021, the US firm found itself in a shootout with SoftBank-owned investment group Fortress.

While CD&R hired Goldman as an adviser and pursued a traditional buyout financing, Fortress looked to raise debt backed by Morrisons’ property. As the bids crept higher and higher, however, it soon reached the limits of leverage that specialist real estate lenders are comfortable with.

“We just couldn’t stretch the financing any further,” said a person involved in Fortress’s bid.

By the time CD&R triumphed in October, Morrison’s price had reached £10bn. Its banks — led by Goldman and BNP Paribas, alongside Bank of America and Mizuho — were now on the hook for an enormous £6.6bn of debt. The banks declined to comment.

Goldman had even more exposure through £1.3bn of risky debtlike “preference shares”, split equally between its in-house fund and private capital firm Ares Management.

“It was an aggressive deal in a hot market,” said one senior debt banker. “You can see why it happened: for years there was no reward for being conservative.”

Considering the risks, Goldman had set the deal’s “caps” — the maximum interest rate the borrower can pay — at uncomfortably tight levels. On Morrison’s top-ranking sterling bonds, if investors demanded yields higher than 5.5 per cent, the banks would start racking up losses.

There was no room for error.

Project Magnum

At Goldman, the leveraged finance bankers rule the roost. Chief executive David Solomon cut his teeth working for junk bond king Michael Milken. The bank’s chief financial officer Denis Coleman formerly ran the same European debt unit that signed the Morrisons deal.

But almost as soon as its bankers began executing the deal they had dubbed “Project Magnum”, things started to go wrong.

Goldman had promised CD&R that they could sell the majority of the debt in sterling, hoping to ape Asda’s £2.75bn junk bond — the largest ever sold in the currency — months earlier. But in October Asda’s bond yields rose to within spitting distance of the Morrison deal’s caps. And investors were expecting to get the new bonds at a better price than Asda’s.

Undeterred, Goldman embarked on a “pre-marketing” exercise the following month, aiming to lock up large orders from big investors before launching the deal to the wider market. They came up empty-handed.

While bankers told investors the deal would leave Morrisons with over four times net leverage, this was based on a heavily adjusted earnings number that reversed the hit the grocer took during the pandemic. Even some seasoned debt investors — usually inured to private equity firms flattering performance — were agog at the scale of the adjustments, which swelled Morrisons’ £745mn of annual ebitda to £1.2bn of so-called “structuring ebitda”.

Yet while fund managers gave Project Magnum a wide berth, bankers hungry for a slice of the deal’s large fee pool piled in. In the final months of 2021, 12 banks opted to join the original syndicate, taking Goldman and the other three banks’ exposure down to just 10 per cent apiece. Some lenders joined as late as December, even after the failed pre-marketing effort.

“Out of everyone involved in this fiasco, those are the guys that should be really kicking themselves,” said one banker, who turned down joining the syndicate at this stage.

“Very un-Goldman”

Goldman has escaped similarly tight spots in the past.

In 2020 as the coronavirus pandemic upended markets, Goldman had been on the hook for the largest bridge loan in Europe, backing the €17bn buyout of ThyssenKrupp’s elevator division. While many predicted heavy losses, the banks got out unscathed after Goldman managed to place some of the riskiest debt privately before waiting for markets to recover.

Its bankers reached for the same playbook with Morrisons, selling £1.2bn of junior debt to the Canada Pension Plan Investment Board at a discount in January. While the banks took a near £50mn loss, the move relieved some pressure and the syndicate believed that fees from the deal would outweigh any hit to their balance sheets by the time they had sold the rest.

As they were preparing to launch a public debt offering, Vladimir Putin launched a full-scale invasion of Ukraine. Credit markets plunged even more deeply into the red, extinguishing hopes of not taking further losses.

As well as the broader market stress, Morrisons’ business was on the front line of the inflationary pressures and cost of living crisis the war unleashed. Project Magnum’s earnings adjustments, which had once seemed merely audacious, now appeared to investors to be completely untethered from reality.

In May, Goldman and the other banks were able to shift £1.5bn of the deal’s top-ranking bonds to a select few investors, taking an over £150mn hit in the process. The hope was that the market would recover by the time they sold the remaining £2.2bn of loans. Instead the prices of Morrisons’ bonds plunged further shortly after the sale.

Many debt bankers argue there was little Goldman could do when markets started to turn given the scale of the deal, equating it to trying to turn around a supertanker.

“None of us are happy about losing money on a trade like this, but particularly given the size I really do think it’s been de-risked incredibly well given the market,” said one of the deal’s underwriters.

Others are more critical.

“It’s just very un-Goldman,” said one rival banker. “They’re usually ahead when the tide starts turning.”

Banks net off the fees and interest they earned on the deal when calculating their total loss, softening the blow somewhat.

Some of the underwriters have also turned to a novel way of avoiding taking a loss: refusing to sell. BNP Paribas raised eyebrows among its fellow lenders when it opted not to shift its Morrisons bonds in May and instead hold them on its balance sheet.

With Morrisons’ secured bonds now trading at around 80p in the pound, banks face further losses on the loans they still need to sell. People close to the deal say they have been able to quietly shift some of these loans above those levels in recent weeks, however, often to lenders in Asia, a route rival bankers warn could be quickly exhausted.

Aside from the banks, funds that invested in the riskier slice of the deal could also face losses. One credit investor argued that the £1.2bn junior bonds, which CPPIB bought at 94p in the pound, should now be marked as low as 50p, which would be a significant loss for the group that manages cash for Canadian retirees. The even riskier preference shares Goldman and Ares poured £1.3bn into could be worth even less. CPPIB and Ares declined to comment.

And then there is the question of what CD&R’s equity is now worth. While the firm has partially bailed out lenders who funded its $5.8bn buyout of the building products group Cornerstone in the US, it has offered no assistance to the banks on Morrisons.

The grocer itself has not sugar coated the challenges it faces in recent presentations to its lenders, describing the market as “very challenging” due to “significant inflation” and “subdued” consumer sentiment.

In response to questions from the Financial Times, CD&R sent over a statement from Leahy, touting the firm’s ability to navigate periods of “economic dislocation and stress”.

“With all our portfolio companies, we carefully craft capital structures to ensure that our businesses have the flexibility to invest and compete irrespective of macro conditions,” he said.

“The structure for Morrisons was designed to provide the business with substantial liquidity to continue to grow.”