As private debt’s unofficial publicly listed arm, the business development company market in the US has mirrored some of the ups and downs of stock market exposure in recent times.
“Early in 2022, BDCs really outperformed broader equity markets, because of a combination of higher interest rates and less expectation of recession,” says Ryan Lynch, an analyst at investment bank and broker dealer Keefe, Bruyette & Woods. “As recession drumbeats started to rise, a lot more BDCs started selling off with the broader markets. In late January, they performed very well because the chatter of potential for an economic soft landing increased.”
It’s not just stock market vagaries that have put BDCs under scrutiny, but also their financial structures. “In the last couple of years, BDCs have had much more of a focus on more recession-resistant businesses like tech and healthcare. The tradeoff is that they are higher purchase price businesses with higher leverage on them as well,” says Lynch. He adds that debt-to-equity multiples are typically in the mid-6s and that anything above this would be “pretty high”, but “I don’t see a problematic situation with credit losses unless we have a hard landing”.
Most industry sources we spoke with for this article do not believe a hard landing is a likely scenario and are, therefore, not too panicked about what lies ahead.
“I have actually become more optimistic over the last six months,” says Kipp deVeer, partner at fund manager Ares Management and head of the Ares Credit Group. “I was never in the ‘world is collapsing’ club. Rather I think what we’re seeing is global monetary policy attempt to slow growth down because inflation is too high. And I think it’s working, which is why I’m more optimistic. You’ve seen declines in inflation, while we continue to see pretty good overall portfolio company performance.”
Not everyone is quite as upbeat about the macroeconomic backdrop, even for those who broadly believe things will pan out fine in the end.
“With the continued challenges associated with inflation, availability of quality labour and supply-chain management, compounded by the impacts of the Federal Reserve’s actions to increase market interest rates over the last few quarters, I expect the US economy to take a step back during the first half of 2023,” says Dwayne Hyzak, CEO of Main Street Capital Corporation. “Despite that expectation, I believe that the US economy will continue to be resilient and will outperform the rest of the global economy.”
When it comes to rising interest rates, the view of most in the market is that there is likely to be a tapering of increases in the period ahead.
“We’re cashflow lenders so I’m not trying to bet on rates in any way, shape or form,” says Dan Pietrzak, co-head of private credit at KKR and co-president and chief investment officer of FS KKR Capital Corp, the firm’s publicly traded BDC.
“I will say that clearly the rising rate environment has driven up interest costs meaningfully, which will impact existing companies and leverage numbers for new deals. In terms of the terminal rate, I think we’re past the 50 or 75 basis point moves and could potentially see two to four more 25 point moves, which could slow if inflation starts to wane.”
John Kline, chief executive officer of BDC New Mountain Finance Corporation, thinks rates will remain elevated in comparison with the last decade “for some time” and that the zero or near-zero interest rate environment was an aberration. He points out one of the key benefits for private credit firms in a higher-rate world: “Given that nearly all of our assets are floating rate, higher base rates do of course increase our earnings power, which benefits our investors.”
Perhaps the biggest challenge for BDCs and other types of lenders is the pressure that higher interest rates will bring to bear on borrowers. But there is a view that most companies should still muddle through the challenges, perhaps with understanding and financial assistance from sponsors as and when necessary.
“Any manager will probably tell you their portfolio’s perfect. The reality is, portfolios should be performing pretty well, unless you are at high octane levels of leverage,” says Ian Fowler, co-head of fund manager Barings’ North American Private Finance Group. “The rapid rise in base rates probably will have the biggest impact on these [overleveraged] companies. We’re not going to see a full year pro forma effect until June.
“Clearly the rising rate environment has driven up interest costs meaningfully, which will impact existing companies and leverage numbers for new deals”
“Five years ago, we had in our loan documentation that companies had to fix 50 percent of their interest rate exposure. When rates were so low, PE firms didn’t want to spend money to fix or swap rate exposure. They were penny wise, pound foolish, and now as rates have risen exponentially and hedging costs have exploded, portfolio companies could experience challenges in servicing that heightened interest burden. Because of that potential risk, we have stress tested the portfolio 5, 5.25 and 5.5 percent. We feel very comfortable at those levels. If it gets worse, we’ll have to deal with it. Now’s the time for managers to have conversations with portfolio companies about getting ahead of this and working on margin preservation assuming companies can’t continue to pass through price increases in a recessionary environment.”
As borrowing pressures increase, driven by rate hikes, few market participants believe the default rate can remain at historically low levels. Reports from ratings agencies have already shown it beginning to creep up – albeit not yet even to average long-term historical levels.
“The challenging macroeconomic backdrop has translated to enhanced credit risk as we kick off 2023,” says Kline. “We expect an increase in defaults to be driven by a number of factors including the rapid rise of interest rates and earnings pressure from both cyclical demand and margin pressure.
“Over the last three to four years, many companies in the private credit market were financed under the assumption that the cost of capital would remain 6-7 percent forever. With the rise in SOFR, loans that yielded 6.5 percent at the beginning of 2022 now cost borrowers 10.5 percent. Many companies structurally cannot afford that sort of increase, particularly if they have topline decreases from cyclical demand and/or margin instability.”
But most have a fairly calm view, encapsulated by deVeer: “I think market [default rates] for credit will continue edging up but they’re still well below the historic average, which is around 3 to 4 percent. If this is a traditional credit cycle, they’ll likely get up to those historical averages but I don’t expect them to be materially higher.”
Grabbing more share
Assuming there is no major blowout to contend with, BDCs appear well set to continue what private credit has always done well since the global financial crisis – take market share from the banks. “In times like now, when public high-yield markets are dislocated and banks are being more stringent with their balance sheet, we really benefit because we have capital and we can provide it with certainty,” says Craig Packer, co-founder of Blue Owl Capital and its direct lending arm Owl Rock.
“Right now, direct lending is really dominating the market for providing financing for sponsors. It’s one of the best environments that we’ve seen, certainly since we started our firm in 2016, for direct lending. As a result, the banks are not able to really compete effectively, and we can. I would expect at some point this year the banks will come back and be willing to underwrite, but it happens to be an especially attractive period for us right now.”
Hyzak says: “BDCs have the flexibility to make investments that may be difficult for traditional banks to execute due to the leveraged lending limits and other restrictions banks have to comply with in their lending practices. As banks continue to pull back from the middle market it increases the BDC industry’s opportunity to provide the same types of debt financing historically provided by traditional commercial banks.”
Performance: ‘Holding up well’
BDCs are proving more attractive than bonds and stocks
“BDCs have held up pretty well over the last year, while bonds and stocks have been crushed,” says Steve Nesbitt, citing the floating rate nature of BDCs and their lack of duration.
Nesbitt is chief executive officer of Cliffwater, an investment advisory firm specialising in alternatives. 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.
He thinks the picture remains bright heading into 2023, with publicly traded BDCs attractive and selling at a discount to NAV. “I think there’s some upside there,” he says. “In a worst-case scenario, if you start at a yield of 11 percent, you might end up with return of 2 percent for 2023 – it’s not a black hole like 2008.”
Blackstone’s Dwight Scott adds: “I think we’re moving into a period of higher base rates in the future; we’ve had good returns in private credit with very low base rates, and now we’re moving into something higher than that. We have good strong private equity sponsors behind us; it’s a very attractive environment in this time.”
DeVeer, however, sees both positives and negatives to banking constraints. “The positive effect is direct lending gains market share, which has been happening for a long time and typically happens during credit downturns where we can consolidate continued share in private credit away from the syndicated loan market. On the other hand, it is more expensive to borrow from the banks for BDCs that need to support their financing activities.”
With public market debt issuance on pause, Pietrzak believes private debt is currently the only game in town. “I think what you have to watch in the BDC space are near-term maturities and other asset/liability mismatches. If you look at our balance sheet, we just extended our revolver in September to five years and we’ve been big issuers of unsecured bonds in the market. We don’t have meaningful debt maturities until 2025 so we get the market benefit on the asset side of things and protection on the liability side.”
There is also a feeling that, for new deals, the environment now is as good as it’s been for a long time. “You’re getting paid potentially hundreds of basis points more because we’re in one of the most lender-friendly environments we’ve seen in a while,” says Pietrzak.
Kline adds: “Total leverage levels are dictated heavily by interest coverage ratios, which is a significant departure from the last 10 years. Generally speaking, leverage levels are 1-2.5 turns lower than the market peak. Spreads are 150-200 basis points wider with three points of upfront fees compared to two points last year. When combined with a 400-basis point increase in base rates, the all-in earnings power of direct lending focused BDCs has increased significantly.”
Shifting to private BDCs
One of the major trends in the BDC market over the last year or two has been a significant amount of capital raised for private BDCs as investors shy away from public market volatility. With private BDCs you are effectively buying the net asset value instead of the stock price and, for public BDCs, stock prices have been volatile, making private BDCs an appealing way for financial advisers to enter the channel.
While publicly traded BDCs offer the same daily liquidity through a brokerage platform as the likes of stocks and ETFs, semi-liquid funds can offer less volatility, at a cost. They typically only allow for a liquidity option on a quarterly basis, and those options are frequently capped at a percentage basis.
“We have both [public and private BDCs], and each brings unique benefits,” says Dwight Scott, global head of Blackstone Credit, the world’s largest BDC manager. “Private BDCs are always open, don’t trade and are much less impacted by public market volatility. They’re valued at NAV, with quarterly liquidity, which allows you to build a portfolio over time, with different vintage exposures, and returns.
The redemption challenge
Outflows will hit management fees
A report from rating agency Fitch Ratings says the recent acceleration in redemption requests in perpetual non-traded vehicles targeting retail investors will have “limited financial impact” on the alternative investment managers overseeing such funds, but “reputation and regulatory risks loom”.
Fitch said prolonged fund redemptions and net outflows would negatively affect management fees, although fund structures preclude outsized redemptions with typical limits of 2 percent of net asset value monthly or 5 percent quarterly.
In Fitch’s view, this cap on redemptions preserves future fee streams even if no further capital is raised and maximum redemption requests are honoured.
BDCs, along with real estate investment trusts, are among the largest retail products offered by alternative investment managers. The issue became a live one for BDCs last year when redemption requests at Blackstone’s perpetual non-traded BDC, Blackstone Private Credit Fund, were around the 5 percent limit.
Meanwhile, some perpetual non-traded REITs – including Blackstone Real Estate Income Trust, KKR Real Estate Select Trust and Starwood Real Estate Income Trust – enforced pre-specified redemption limits after investor requests exceeded previously established parameters.
“On the public side, there’s more liquidity, and in exchange you’re exposed to greater volatility that public markets can introduce. Depending on the market environment, sometimes they trade at a premium to NAV and sometimes not.” What’s not in favour at the moment is committing capital to new funds, and BDCs are not immune from investor caution. “The [fundraising] environment is definitely more challenging than it was six to nine months ago,” says Pietrzak. “I don’t think that’s too surprising. Investors, particularly in the private wealth segment, tend to slow down their capital deployment in times of market volatility.”
Nonetheless, he adds: “I think that more and more private wealth investors are looking to diversify their holdings into alternative investments, and investing in BDCs can be a good way to do that.”
DeVeer says: “I think this is a year where market activity could continue to be slow and everyone consolidates and re-underwrites their credits where they need to. I think there’s going to be disparity in performance. The managers that have strong teams, have underwritten well and know how to manage risk in a more difficult environment – I believe they will do better than others.”
Given the BDC market has seen a fair amount of consolidation in the past, could tougher market conditions produce more examples? Pietrzak would not be surprised to see some consolidation plays as “I do think it’s easier to operate with a bigger balance sheet”.
Ares has been at the forefront of the consolidation trend, buying Allied Capital in 2010 and American Capital in 2017. However, deVeer believes BDC consolidation only tends to arise from what he describes as a “little bit of a violent event” such as material underperformance or shareholder activism. “In most cases there’s not really an incentive for BDC managers to sell – even in the case of underperformance – because the manager would be parting with what can be a long-term management agreement with attractive terms.”