BDCs’ big promises

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Good morning. Unhedged’s spotless record as a contrarian indicator persists. A day after Rob’s bald-faced Nvidia scaremongering, the chip stock leapt 7 per cent on no news at all. Remarkably, it did so on the same day that the 10-year Tips yield hit its highest point since 2008. What happened to long-duration tech stocks trading down on rising rates? This market makes no sense to us. Correct our confusion: [email protected] and [email protected]. 

BDCs (and the future of private credit)

Back in July, we wrote about private credit coming into its own as an asset class. We argued that the PC pitch to investors, its “special sauce”, had four ingredients. They were:

1. Neglected borrowers. Standard sources of credit, such as the bond or leveraged loan markets, edges out borrowers with specific needs. Private credit can lending to these trickier companies, and charge higher spreads.

2. Tighter contracts. Private lenders say they’ve avoided the “cov-lite” watering- down of contracts that has taken over elsewhere in debt markets. 

3. No mark to market. Investors are insulated — at least optically — from price volatility.

4. Bilateral lending relationships. Active engagement with borrowers can improve the efficacy of workouts and lift recovery rates.

This all seems reasonable enough in the abstract. The catch is that the case for private credit is untested. At its current scale, the industry hasn’t gone through a serious credit cycle. But there is one segment of private credit that has been around at some scale for a bit longer: business development companies. Firms structured as BDCs now hold a quarter of assets under management in private credit. Perhaps BDCs hold clues about where private credit is heading?

At the most basic level, a BDC is a tax-efficiency play. Under a 1980s law, BDCs were set up to channel funds towards middle-market companies that lack the sort of capital markets access bigger players enjoy. The deal is that BDCs must invest 70 per cent of assets in private US companies or smaller public ones, maintain a moderate debt-to-equity ratio, and distribute 90 per cent of taxable income as dividends. In return they pay no corporate tax. They are structured as closed-end funds: after the BDC raises capital in a share issuance, investors can buy the shares from other investors, but these purchases do not contribute new capital to the fund.

But (in a strong contender for the unintended consequences hall of fame) a structure set up to get capital to up-and-coming businesses is now mostly a way to finance middle-market leveraged buyouts. Eighty per cent of BDC transactions involve a private equity-sponsored business, estimates Mark Wasden and his team at Moody’s. 

BDCs growth has boomed in the past couple years, in no small part because of the exceptional debut of Blackstone’s Bcred in 2021. In two short years, Bcred has gone from $0 under management to $48bn, and is now the biggest BDC. This chart from LCD earlier this year shows the shift:

The secret to Blackstone’s success is that it has reinvented the BDC wrapper. To understand how, consider a traditional, publicly listed BDC that wants to raise capital to expand. Because its shares often trade at a discount to net asset value — a general tendency of closed-end funds — new issuance would dilute existing shareholders. This constraint explains why many BDCs have had to grow inorganically, through acquisitions, rather than by selling more shares. 

Blackstone’s Bcred sidesteps this. It has pioneered a new structure of “perpetually non-traded” BDC, which is open to wealthy individual investors but isn’t listed on a stock exchange. It can issue as many (private) shares as it wants, without worrying about the public-market discount. In place of the liquidity that public markets would normally provide, Bcred will redeem up to 5 per cent of shares outstanding per quarter. That’s illiquid, and Bcred has started hitting its redemption limits lately. But still, many investors seem content sitting back and collecting 11 per cent distribution yields (comparable to most BDCs).

How have BDCs performed historically? At a high level, some BDCs that have fulfilled, or perhaps almost fulfilled, the promise of near-equity-like returns from a fixed-income investment — the very promise that so many private credit funds are making today. Here is the 10-year total returns of the Cliffwater BDC index compared to the S&P 500:

Now, that looks like a blowout win for the S&P, but the BDCs still managed to compound returns at 7 per cent a year for a decade — a pretty high number for a fixed-income investment, and much better than a typical high-yield bond fund or bank loan ETF. Within that index, of course, there is a wide dispersion of returns:

A couple points to keep in mind when looking at this chart. First is that this is not a representative selection, because all the BDCs depicted have survived for at least 10 years. There are plenty of shorter-lived BDCs with bad track records. That said, both Ares and Hercules have compounded returns at very close to the S&P for the past decade (which has been a great decade for stocks). This is, one must say, impressive for a fixed- income investment with a debt to equity ratio of at most 2 to 1, and often much less. This reflects both the very high spreads available from the assets the BDCs buy (mostly first-lien loans on sub-investment-grade middle-market companies) and to the very low default rates of the past 10 years. 

It is also important to note that the best BDCs have managed to deliver these returns despite paying fees out to their managers that one credit investor described as “outrageous”. Many BDCs are run by asset managers, who take fees based on assets under management and investment income. At Ares, for example, the fees are 1-1.5 per cent of assets, depending on the amount of leverage used to finance them and (to simplify slightly) 20 per cent of net investment income that exceeds a hurdle rate of 2.2 per cent return on net assets.

These are hedge fund-like fees, so you can see why an asset manager would be eager to set up a BDC, and one can imagine how grouchy those asset managers must have been as they watched Bcred come in with lower fees (a 12.5 per cent charge on net investment income, with a higher hurdle rate) and absolutely hoover up client assets.

We were frankly surprised, looking back, at how strong the returns at the best-managed BDCs have been over the past 10 or more years, and this holds out promise for what the best private credit firms might be able to achieve in the decade to come. This is all the more true because the best private credit funds will have more of the “secret sauce” — needier borrowers, tighter contracts, limited mark-to-market, bilateral relationships — than the BDCs, who mostly buy bog standard buyout loans.

But, to repeat, BDCs established their strong track records in a relatively short period defined by low defaults and very low rates. That’s all over now. How well middle-market leveraged lending will work, for either BDCs or private credit funds, when higher rates have both increased defaults and tightened lending spreads remains to be seen. (Armstrong & Wu)

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