BDCs vs the credit cycle

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BDCs and private credit, part 2

We’ve been writing about business development corporations, the form of private credit investing with the longest public record. But that record is not easy to assess, because recent years have been so extraordinarily easy on credit investors. There have been very few defaults, and until 2021 the rate environment was benign, too. In a less gentle environment, underwriting skill will matter a lot in protecting the high yields that private credit investors have been promised.

For BDC investors, it takes a lot of work and knowledge to assess the underwriting capacity of a BDC manager — collecting and assessing default and recovery rates is hard. There is, however, an easily accessible, if approximate, proxy for this: net asset value per share over time. 

Recall that BDCs are required to pay out 90 per cent of their profits. This makes it challenging for them to increase net asset value by retaining and reinvesting interest income. What they can do, however, is erode net asset value per share by lending to borrowers who don’t pay the money back, or through dilutive share issuance where the proceeds are malinvested. So, as a first step in looking at BDCs, investors can look for stable-to-slightly-up net asset values over time. This is much better than being hypnotised by high and steady dividend yields. 

As it turns out, the record of BDCs vary a lot in this record. James Morrow, founder and chief executive of Callodine Group, an asset manager focused on yield which owns a lot of BDCs, put it to us like this: “The five-year NAV record of public BDCs has an enormous range. I’m surprised people invest in certain BDCs at all, which just appear to be consistently burning capital.”

We compared 31 publicly traded BDCs on the five-year NAV test Morrow suggested. This table will be hard to read for those of you on mobile, but we wanted to include it so hardcore credit geeks could pick through it at leisure:

A couple of things stand out, in addition to the sheer variety of outcomes on NAV/share over time. One is that total shareholder return, which is dominated by the BDCs’ high-dividend yields, is not all that tightly correlated with stable NAV/share. Some BDCs, by dilution or malinvestment or whatever, have destroyed a lot of value per share but have still managed to post reasonable total returns by keeping the dividend up. This won’t be possible in a proper down cycle.

And there is some correlation between returns and NAV/share, as a scatter plot shows:

Another thing worth noting is that some BDCs backed by famous asset managers have not exactly covered themselves in glory. Companies whose names include “KKR”, “BlackRock” and “Goldman” have all lost good chunks of NAV per share. Look at the record, not the name on the tin. The same will go for any private credit investment.

Are BDCs’ hedge fund-like fees justified? Many investors are leery. One credit portfolio manager describes a “stigma” around older BDCs that have neither delivered superior returns nor lowered fees. And everyone in BDC-world we spoke with agreed that pressure to reduce fees was building.

The question is by how much. There is probably a limit to how low fees can go. BDCs are not stock ETFs, where expense ratios are easily cut to the bone. Even the most generic BDC is dealing with relatively complex stuff — originating and underwriting loans. “What matters is fees relative to strategy,” says Morrow. If the investment strategy of a BDC is similar in complexity to that of a fund working in the leveraged loan market (private credit’s closest competitor), the fees should match. But if a BDC does speciality loans to obscure companies, higher yields may justify higher fees.

“People get caught up on fees, but you’re paying for a curated return and the lack of volatility,” Morrow added.

But again, those returns are unproven across a true credit cycle. As we’ve written before, in the past decade private credit, including BDCs, has edged out banks to nab business from the high-yield bond and leveraged loan markets. Private credit boasts of faster, more customised, more private execution. But do they have the same capabilities to work out troubled loans as banks, which are veterans of many cycles? Jane Buchan, who co-founded the fund-of-funds Paamco, sounded a sceptical note in the Financial Times on Tuesday:

While many of these direct lending asset managers have strong credit modelling and underwriting skills, the absence of an individual who works with the company to solve financing issues before they become significant is noticeable. In other words, there is no one doing the job of a commercial banker . . . 

But what happens when the music stops? . . . The large asset management lenders in large private equity-backed deals will probably be OK, but the problem lies with smaller asset managers . . . Who from these smaller shops is going to have the ability to work closely with these companies when they enter periods of uncertainty? If these managers do not have the skills, then to whom are they going to sell these loans? 

Private credit likes to argue that risk shifting from the depositor-backed banking system to investor-backed lending funds helps the system. As Matt Freund, who co-manages Barings’ BDCs, argues:

I’ve worked for a couple of banks, and I believe the principal function of banks as it pertains to this market is not to provide credit. Credit — as a product — is better served in asset management environments like ours where investors are willing to take the risk, and frankly if it doesn’t work out, the investors bear the outcome if the transaction doesn’t produce a positive internal rate of return.

Morrow thinks that scale will lend stability in a downturn. He pointed to one of the few lived examples of how private credit copes, the 2015-16 mid-cycle slowdown, when defaults ticked up, fuelled by busts in the energy sector. In that cycle, “workouts were handled well by big PE shops who now have private credit businesses”, he said. The bigger firms were able to keep their investments afloat by various means, such as by injecting fresh equity. So in BDCs, “we’re biased towards those bigger firms”, Morrow said.

At least one BDC bigwig is concerned about smaller, newer firms, too. Oaktree’s Matt Stewart, who is chief operating officer of the firm’s BDC, said that while they have plenty of people forged in the fire of distressed-debt investing, “a lot of other managers don’t have those sophisticated workout people in-house, because they’ve started up more recently or haven’t focused on that area”. He says it isn’t just how lenders handle workouts once a loan goes bad, but also how the loan is underwritten in the first place:

Am I protecting myself? Do I have enough asset coverage? Do I have the covenants in place to call a default? You have to set yourself up for success at underwriting — a lot of the work comes in upfront.

As the credit cycle turns, beware inexperience. (Armstrong & Wu)

One good read

The New Yorker on the DeSantis mess.