(Bloomberg) -- Leveraged buyouts are flooding the U.K. with more junk debt than ever -- and that’s bad news for the finances of some of the country’s best-known companies.

Britain’s market for high-yielding, non investment-grade, bonds has ballooned by more than a third in the past 12 months as private equity firms, lured by a benign regulatory environment and the so-called Brexit discount, have snapped up companies from supermarket chain Asda Group Ltd. to roadbuilder John Laing Infrastructure Ltd. But as the buyers typically finance their acquisitions by loading debt onto their targets, it’s a trend that could leave many companies vulnerable in the future. 

“The important question is to understand the private equity-investment thesis: is there actually a plan that will result in value creation or is it more about financial engineering?” said Hugo Squire, a high-yield portfolio manager at Schroders Investment Management Ltd. in London.

While the flurry of deals is testament to the allure of British businesses, it also comes at a critical moment for many companies. The fastest inflation in 30 years is squeezing consumer demand while strengthening the case for the Bank of England to accelerate a cycle of interest-rate increases that would further tighten corporate borrowing costs.  

“You need to not just consider if the takeover structure makes sense now but whether they still make sense with higher interest rates,” said Squire, who handles $1.8 billion of assets. 

The prospect of rising borrowing costs has so far done little to cool the frenzy of transactions. Private-equity buyouts of U.K. companies climbed to 33.8 billion pounds ($46 billion) in 2021, the most since 2007 and up 64% from the year before, according to data compiled by Bloomberg. 

As deals have gotten done, the sterling junk-bond market has swelled to almost 43 billion pounds, 34% higher than the same time last year and just short of the five-year high reached in mid-December 2021. Clayton, Dublier & Rice’s purchase of Wm Morrison Supermarkets Plc -- which may trigger the largest leveraged finance deal of a British company in more than a decade -- and potential interest in high street names such as Sainsbury Plc and Marks & Spencer Group Plc could enlarge the market further. 

That growth shows how buyouts dilute the quality of company debt. The financing package for the Morrison acquisition -- due to launch in the coming weeks -- could result in a four-step cut in the company’s debt rating from the Baa2 grade it enjoyed prior to the acquisition, according to Roberto Pozzi, a credit analyst at Moody’s Investors Service in London. 

“We could see further downgrades in the sector if more companies are taken over through leveraged transactions, as typically used by private equity funds,” he said. 

Moody’s already downgraded Morrison to junk in December, citing the takeover. Handing a junk rating to a company removes its bonds from the wealthier investment-grade gauges investors use to measure their performance, prompting them to sell the securities from their portfolios.

Asda is another case in point. Since the Issa brothers and private equity firm TDR Capital acquired the Leeds-based store operator less than a year ago, its borrowing costs have surged, with the yield on its 2026 note climbing 163 basis points to 4.63%. The buyers had lumped 2.75 billion pounds of debt onto Asda’s balance sheet.

For sure, some buyouts have been beneficial. Pet care company IVC Evidensia, created by Swedish buyout company EQT in 2017 by merging two of its portfolio companies, conducted a 3.5 billion-euro ($3.9 billion) private-funding round last year that valued it at 12.5 billion euros.

“Money is still very cheap in historical terms, corporate balance sheets are in good shape and private-equity firms have dry powder,” said Adam Darling, who manages $968 million at Jupiter Asset Management Ltd. in London.

Jupiter is avoiding the debt of potential acquisition targets, especially bonds with a high cash price, as a lot of corporate debt has a redemption option around par in the event of a change of ownership.

“Any companies with significant real assets that can be levered are potential targets, and you can lose a lot of money if you are positioned incorrectly,” Darling said. 

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