Something wicked this way comes (maybe)

Highland Capital Management believes 2013’s massive level of corporate debt issuance spells disaster or, at the very least, distress. 

Instead of relying on organic, GDP-led growth, many mid-market companies sought to sustain their financial health through strategic acquisitions or refinancings, many of which were financed by the issuance of new bonds, PIKs or leveraged loans. That demand for financing provided a boon to non-traditional lenders, many of whom lack the institutional expertise to properly assess credit quality, according to Highland. 

“I don’t think we'll see default rates ticking up much in the next 12 months,” Highland’s head of credit research Trey Parker said in a panel earlier this week. “But what’s happening now is sowing the seeds.”

Highland aims to harvest that crop by preparing its distressed specialists for a busy down cycle they expect to buffet the economy at some point in the next few years, Parker said. The firm will keep an eye on credits on which they previously passed as future distressed opportunities, a tactic chief investment officer Mark Okada labeled “alpha-by-avoidance”.

“You can’t just look at the leverage multiples, you have to look at the documents too,” he said. “There are [already] cracks appearing in deals.”

Several market observers, including The Financial Times and The Blackstone Group’s Joseph Baratta, have sounded the alarm on this, pointing out the current environment bears all the hallmarks of a bubble. Relatively few have made it explicitly known that they plan to pursue the resultant opportunities.

Predicting these so called “cracks” is a tricky business, however, and it hasn’t been helped by the fact that readily available financing contributed to falling default rates, [as the additional liquidity helped firms refinance existing debt with less aggressively-covenanted loans] something that was pointed out by S&P just this week.

“Even entities at the lowest end of the ratings spectrum were able to come to market, which is partly the reason why defaults have been less frequent in 2013,” according to S&P Ratings Services’ latest global report. “Globally, only 2.2 percent of speculative-grade companies defaulted in the 12 months through the end of October 2013, down from 2.5 percent in 2012.”

Couple that with a stronger global economy and tempered optimism seen on both sides of the Atlantic (at least, compared to this year’s fears of a US default or a more widespread Eurozone crisis), there is substantial evidence that Highland’s assertions about a looming collapse may be overblown.

Even so, preparing for the worst is hardly a bad thing, and the level of caution shown by Highland provides a welcome lesson on how to anticipate a crisis before it begins. Better that than scramble for answers at its outset. 

The level of discourse surrounding distressed opportunities, as well as the many other opportunities in the private debt market, was one of the motivating factors behind the launch of Private Debt Investor earlier this year. As we have with our other titles, we’d like to harness the reflective spirit of the holidays to consider what firms or funds have led the way in this space – as well as all the other segments of the private debt industry – over the last year.

So please take a moment to vote in our first annual PDI Awards, which you can access here. It will only take a few minutes, but your input will help to make these awards the most robust and meaningful in the industry.