BDCs are dusting themselves down

As private debt’s unofficial publicly listed arm, the business development company market in the US has experienced some of the ups and downs of stock market exposure in recent times, but higher interest rates and a declining expectation of recession have combined to enable BDCs to perform relatively well compared to the broader equity market.

Investment advisory firm Cliffwater produces in-depth research on the BDC space and found that, in calendar-year 2022, BDCs were down 8.6 percent, while the aggregate bond index was down 13.4 percent and stocks were down 18.0 percent. Cliffwater CEO Steve Nesbitt thinks the picture is fairly bright in 2023, with publicly traded BDCs attractive and selling at a discount to NAV.

“I think there’s some upside there,” he told us for our March 2023 issue cover story on the BDC market, to be published on 1 March. “In a worst-case scenario, if you start at a yield of 11 percent, you might end up with a return of 2 percent for 2023 – it’s not a black hole like 2008.”

It’s not just stock market vagaries that have put BDCs under scrutiny, but also their financial structures. BDCs have tended to focus in recent years on more recession-resistant businesses like tech and healthcare. The trade-off is that they have tended to be higher purchase price businesses with higher leverage and debt-to-equity multiples typically in the mid-sixes. However, few market sources we spoke with predicted too much of a problem with credit losses unless the expected economic soft landing ends up being a hard one.

When it comes to new deals for BDCs, there is reason to consider the current vintage one of the most promising the industry has seen. John Kline of New Mountain Finance Corporation points to leverage levels 1 to 2.5 turns lower than the market peak; spreads 150-200 basis points wider; three points of upfront fees compared with two points last year; and a 400bp increase in base rates. “The all-in earnings power of direct lending-focused BDCs have increased significantly,” he said.

Moreover, as the banks struggle with leveraged lending limits and other restrictions, BDCs are discovering some new market space to move into – increasingly stepping in to provide the same types of debt financing historically provided by the traditional commercial banks.

While there’s no debating that 2022 did plenty to confirm the old adage that stocks can go down as well as up, the BDC market appears to be emerging in decent shape.

Write to the author at andy.t@pei.group