Fund Manager Says Red-Hot Private Debt Market May Cool Off

Credit shop Highland Capital says the asset class is taking in so much capital that returns are under threat.



Institutional investors pouring capital into the private debt markets has given alternative asset manager Highland Capital reason to be wary about the market’s value proposition.

“There is a significant amount of dry powder on the sidelines that only continues to grow,” the firm said in its 2018 credit outlook, released Monday. “We think this money may end up chasing deals aggressively, likely at tighter spreads.”

The firm joins a growing number of asset managers, including BlackRock and JPMorgan Chase & Co., that have shared their thoughts on the private debt market over the past few weeks. Highland’s views on private debt are far more bearish than those of JPMorgan or BlackRock, with the firm calling the market concentrated and under-deployed.

According to Highland data, private debt funds had accumulated nearly $250 billion in dry powder by the end of 2017. That looks unlikely to slow down: according to a BlackRock report published on January 18, 58 percent of the firm’s clients said they plan to allocate more money to private credit.

[II Deep Dive: Investors Plan Larger Allocations to Private Markets in 2018, BlackRock Survey Finds]

This influx of both money and investors into the private debt markets, coupled with a perceived lack of volatility, has Highland concerned.

“Most of those funds are held at cost, until there is otherwise a problem in the portfolios,” the report stated. “We think this potential volatility has been downplayed significantly, and that opaqueness within the underlying assets could be a risk to the cycle.”

In other words, most of the underlying assets in a private debt fund are marked at how much they cost to purchase. That marking is not reflective of the volatility of the market, which means the assets could actually be worth less than their valuation.

Another problem with private debt, according to Highland, is that expected regulatory changes could significantly affect returns.

“For funds that invest in this private debt market, the banking deregulation that we expect to see should continue to drive down returns, making it more and more challenging for fund managers in the space to meet the target return expectation that they originally advertised,” according to the report.

That’s because following the financial crisis of 2007 and 2008, banking regulations, particularly Dodd Frank, drove banks away from the credit markets. Private debt fell into favor for a time, but regulations are likely to be relaxed soon, which is a huge risk to the market, Highland says.

Instead of private debt, Highland suggests that value can be found in the bank loan market. These assets “may offer a solid coupon plus some spread tightening return over that period,” according to the report.

This strategy is divergent from one recommended in a January 17 report from JPMorgan, which suggested coping with a late-cycle credit market by investing in distressed or event-driven credit strategies.