Business development companies finished 2023 with flying colours, despite early volatility and fears of a liquidity crunch or recession. Although there is some unease about asset quality and interest coverage, the sector appears poised for another solid year.
Amid a stronger than expected US economy, BDCs returned 11.15 percent, annualised, through the third quarter of 2023, outpacing the index’s return since its September 2004 inception by nearly two percentage points, according to the Cliffwater Direct Lending Index.
“It was a very good year for both public and private BDCs,” says Cliffwater chief executive officer Stephen Nesbitt. He expects continued good fundamental performance this year, albeit at a slower 9 or 10 percent, near the historical average. Earnings are anticipated to remain relatively strong in 2024, although Chelsea Richardson, a senior director at Fitch Ratings, believes they are approaching peak levels, and the benefits from higher interest rates could be partially offset by rising non-accruals and/or spread compression.
While private debt fundraising has generally languished, the value of BDC asset portfolios rose 22 percent in 2023 through Q1, to nearly $300 billion, per S&P Global Ratings. Most of that growth came from non-traded BDCs, whose loan assets jumped 41 percent to $119.9 billion in the period. Loan assets of non-traded BDCs now surpass those of publicly traded BDCs, which rose by just 4 percent, to $114 billion.
“We believe we’re well positioned for another strong year,” says Craig Packer, co-president of Blue Owl Capital. He notes that Blue Owl’s two non-traded funds together have been raising some $500 million a month and believes there is still significant untapped demand for perpetual non-traded BDCs being sold in the private wealth channel.
“The big growth will be in publicly offered non-traded and privately offered BDCs,” says Steven Grigoriou, a partner in Simpson Thacher’s registered funds practice. Those funds’ registration requirements give investors “all the transparency of any other publicly traded company with regular reporting requirements”.
Among the funds’ other attractions: foreign investors and endowments can avoid paying federal tax on them, and, for a number of new BDCs, institutional investors don’t have to deal with the capital calls of direct lending funds.
Non-traded BDCs have quickly reached critical mass, given they arrived just three years ago with Blackstone’s launch of Blackstone Private Credit Fund (BCRED). That fund is the largest of its kind, with a hefty $50.5 billion of assets as of 30 November 2023.
Although BCRED and some other funds experienced redemptions that reached their quarterly cap of 5 percent in late 2022, BCRED’s fundraising has rebounded, with Q4 inflows as of 6 December reaching $2.7 billion, rising about 8 percent from Q3 and the highest since Q2 2022, according to an investor letter.
Last year alone, six perpetual non-traded BDCs were launched, with Ares, Oaktree Capital, Goldman Sachs, Golub Capital and Fidelity joining the party. That helped non-traded BDCs capture 39 percent of total sector assets as of Q3, according to Fitch. Oaktree Strategic Credit Fund led the pack, with growth of 323 percent in the period, per Fitch.
Interval funds are another growth area, given their lower leverage levels and requirements to provide liquidity at regular intervals. Interval funds of all asset classes have surged in the past few years, to $88 billion, with credit interval funds, at $40 billion, accounting for nearly half of the total, per Cliffwater.
Recent elevated rates have benefited BDCs by helping them earn an attractive spread over liquid alternatives. But “as higher rates persist for longer, even if there are cuts, there will likely be a general increase in non-accruals, debt modifications and PIK instruments across the space, which can lead to potential losses and volatility”, says Matt Stewart, a managing director in Oaktree’s global private debt strategy.
Nevertheless, at Ares Capital – the largest publicly traded BDC – “our financial metrics have generally indicated that borrowers have been able to deal with rising rates”, says Kort Schnabel, Ares Capital’s co-president and Ares Management’s co-head of US direct lending.
Indeed, non-accrual rates at Ares Capital are just above 1 percent as of Q3, well below their historical average. Although Schnabel sees industry defaults rising – perhaps because of the lagged effect of rate increases – he believes they will remain at manageable levels.
Pressure on BDCs will be largely dependent on the vintage and sector exposure of their investment portfolio, says Dan Pietrzak, global head of private credit at KKR. Vintages after 2022 – a more lender-friendly market with greater certainty that interest rates would stay higher for longer – should perform better than loans underwritten prior. “With interest rates higher, there’s less room to manoeuvre if there’s a challenge or issue in a mid-market company, especially one affected by wage inflation,” says Pietrzak.
“Firms that don’t have the resources, investing history and experience to be able to navigate complicated markets will have a harder time,” says Grishma Parekh, co-head of North American senior lending at HPS Investment Partners.
No deterioration seen
At the moment, “private credit as an asset class is demonstrating a higher degree of resilience, part of a long-term secular trend”, says Jonathan Bock, co-CEO of Blackstone’s BDCs.
Although more fragile businesses in hyper-cyclical or capital-intensive sectors, or those orientated to consumer commodities, are starting to experience some interest-rate-driven distress, “generally, if you were insulated from those industries, you did pretty well”. Bock says Blackstone’s portfolio continues to perform well in this environment, and its defaults remain lower than those of its peers.
Some managers, like Blackstone, are finding value in bigger deals. Bock notes that companies with EBITDA of $100 million or more are growing roughly seven times faster than those with earnings of $50 million or less. Very few managers have the capital to grow with these companies, he says, and the market is valuing those managers above book value.
Private credit has taken a “significant share” of business from the banks over the past 12-18 months, says Ares’ Schnabel, with “only a handful of scaled direct lending managers able to write cheques north of $500 million per transaction”.
Although he expects that to moderate as the syndicated loan market revives, he says Ares anticipates future periods of volatility will create further dispersion among private credit managers, and that some smaller managers will have greater difficulty sourcing deals.
Although private credit is increasingly landing larger deals – including those for bigger, sometimes public, companies – a Moody’s report last autumn noted that “despite a history of stronger terms, private credit is dropping maintenance covenants in larger deals”.
The moribund M&A market has pressured “those direct lenders that don’t have a large, established portfolio and have raised capital”, says Ian Fowler, co-head of Barings’ global private finance group and president of Barings BDC.
“If you’re relying on new M&A activity, you’re playing with fire.” He says there is an advantage to transacting in the existing portfolio, where sponsors are adding on businesses with lower multiples to reduce their cost basis. “When the M&A market does open up, it will be a watershed moment.”