Alternatives firms are sitting on $1 trillion in dry powder – and trying to strike a balance between patiently holding out for good deals and yielding to pressure from investors who want them to start putting their money to work. It’s just one risk facing the private equity and private credit markets, according to JPMorgan Chase & Co.’s asset management unit.
As of the end of 2018, alternative asset managers had $800 billion in private equity dry powder and another $200 billion in private credit funds that have been raised but not invested. With so much capital waiting to be deployed and investors eager for deals, borrowers get the upper hand and lenders may not deploy the safeguards they would in a tighter market.
“We hear some limited partners are pressing GPs to put that money to work,” said David Lebovitz, global market strategist at JPMorgan Asset Management, during a lunchtime discussion of its quarterly guide to alternatives. “There’s risk in managers sitting on capital,” he added.
According to data collected by JPMorgan, private equity and credit fundraising peaked in 2017 at almost $700 billion, with another $536 billion raised in 2018. “Dry powder is concentrated in mega funds,” Lebovitz said. “It’s a 2017 vintage problem.”
The belief at JPMorgan Asset Management is that the current credit cycle won’t end well, although Lebovitz emphasized that he doesn’t think a credit downturn will create systemic risk problems. In part, that’s because assets managers now dominate credit markets as opposed to banks. In 1994, 71 percent of participants in the U.S. leveraged loan market were global banks, with the remainder made up of non-banks and funds. By 2017, that relationship had flipped entirely, with non-bank companies and funds representing 91 percent of leveraged loan market participants.
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The growth of private credit, which often finances private equity transactions, poses another market risk. With plenty of money to borrow, private equity GPs and strategic buyers have pushed up company valuations.
Using the leveraged loan market as a proxy for the deterioration of credit quality, JPMorgan reported that 80 percent of U.S. leveraged loans were “covenant-lite” as of the end of 2018, meaning borrowers of money are shaping the terms of the deals in their favor. “If you are a borrower and can dictate terms then we are in a late [credit] cycle,” Lebovitz said.
According to JPMorgan, approximately 50 percent of leveraged loans are funding mergers and acquisitions and leveraged buy-outs. Lebovtiz said this creates two risks: the risk that the deal itself won’t work out and the risk of the leverage. As a result, JPMorgan is focusing on smaller deals and operational changes that can be made to increase returns.
Anton Pil, head of JPMorgan Asset Management’s $100 billion global alternatives business, said the only opportunities in private credit are short-term mega-deal financing, litigation finance, and catastrophe insurance. “We are shifting to distressed and special situations,” Pil said. “As a borrower it’s great. But I don’t want to lend money now. This will end poorly.”
Pil said retail investors, who are increasingly investing in private equity and credit, should instead put money into real assets, because the amount of dry powder makes those two asset classes too risky.