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Investors beware: BDCs show stress in private credit

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Private credit in the US is not so private.

Amid the explosion in corporate direct lending funds, business development companies have existed for decades making loans to mid-market businesses. BDCs are publicly traded vehicles created by an act of Congress in 1980 to promote access to capital for companies well outside the Fortune 500. For equity investors, BDCs provide healthy cash dividends that theoretically should be safe given the senior, secured status of their lending.

In the past 10 years, amid a surge that has seen BDC asset values rise to $300bn, the S&P BDC index has returned a healthy 9 per cent annualised rate, including dividends.

The new private credit funds by definition do not publish their returns or delinquencies. As such BDC reporting has become a window into how borrowers are coping with the elevated interest rate environment. In April, Moody’s put the bonds of three BDCs — managed by KKR, Oaktree and BlackRock — on negative outlook. 

Each has seen loan “nonaccruals” jump upwards to between 4 per cent and 9 per cent. Moody’s overall BDC nonaccrual rate is about 1 per cent. Moody’s also pointed out that BDCs were increasingly toggling their loans to “payment in kind”, a feature that reduces borrowers’ cash interest expense and can be a signal of stress. 

BDCs have been criticised as instruments where their external sponsors extract high fees and pursue asset growth over vigilant underwriting. A study cited by Morningstar calculated that BDCs charged an effective fee on net assets in excess of 5 per cent.

There are also wide performance gaps among BDCs. The BDC sponsored by Ares Management is widely considered to be the best-run of the lot (It is helping to fund the $7bn buyout of Squarespace, announced on Monday). It trades at 1.1 times net asset value. FS KKR, one of the downgraded BDCs, trades at just 0.8 net asset value making it difficult to issue new equity. 

Line chart of Indexed to 100 showing BDCs invest in senior corporate loans and have offered healthy shareholder returns

By being publicly traded, BDCs are a form of permanent capital. But private BDCs are increasingly common: Blackstone has formed one called BCRED. This aims to draw retail investors with the promise of big dividends and total returns.

Corporate credit may continue to be a winning sector if central banks keep up their habit of intervening whenever the credit cycle threatens to turn. But public market investors increasingly have the choice to not just buy corporate loan exposure via BDCs: BDC sponsors such as Ares, KKR and Apollo are themselves listed.

Given the charges these groups levy for managing BDCs, the parents may themselves be the better bet.

sujeet.indap@ft.com

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