Fitch Ratings said in a report that tentative signs of a pickup in large leveraged buyout and M&A transactions, financed in large part by leveraged loans, may boost fee revenues for major U.S. banks in the first quarter, but Fitch sees the potential for any sustained rise in deal activity to increase balance-sheet risk for major U.S. banks in the process.

Although the impact of large-scale leveraged transactions on advisory fee and underwriting revenues will be positive during the first quarter, Fitch notes that banks may be assuming more risk on their balance sheets – both as a result of much larger deal size and higher debt-to-EBITDA multiples in some recent leveraged transactions.

The foundation for an eventual increase in LBO and M&A activity has been laid, even in a slow-growth economic environment. U.S. corporate cash positions are very healthy, and a wave of refinancing activity by firms has increased the amount of cash available for acquisitions. In addition, private equity firms have ample dry powder (committed but unused capital) to put to work in leveraged deals. Interest rates and credit spreads remain quite low, making deal financing costs very attractive versus historical norms.

Fitch said the sheer size of available buyout capital held by private equity firms (estimated at $342 billion by data provider Preqin) points to the potential for a surge in leveraged deal activity over the next few years, assuming global macro conditions improve.

Large U.S. banks, with balance sheets fortified, now have ample lending capacity, and they are likely to look more favorably on participation in deals. In doing so, however, they may retain more risk on their balance sheets and run the risk that any rapid rise in interest rates and credit spreads will limit their ability to sell down risk and syndicate loans. Large exposure to leveraged credit caused problems for many banks, when liquidity evaporated in the latter part of 2007 and 2008. While current exposures fall far short of pre-crisis heights, growth in leveraged loan books nonetheless represents a risk that could grow in importance over time, Fitch notes.

To read the entire Fitch report, click here.