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Good morning! It seems that Unhedged continues to be a reliable contrarian indicator. Just a day after Rob’s pessimistic Nvidia prediction, the chip stock surged 7% for no apparent reason. Even more curious, this happened on the same day that the 10-year Tips yield reached its highest level since 2008. It’s puzzling to see long-duration tech stocks not responding to rising rates. We’re confused by this market behavior. Help us out: [email protected] and [email protected].
BDCs and the Future of Private Credit
In July, we discussed how private credit was gaining recognition as an asset class. We highlighted four key factors that made private credit appealing to investors:
1. Neglected borrowers: Private credit fills the gap left by traditional credit sources, allowing them to lend to borrowers with specific needs and charge higher interest rates.
2. Tighter contracts: Private lenders avoid the common practice of diluting contracts, providing more security to investors.
3. No mark-to-market: Investors are shielded, at least on the surface, from price volatility.
4. Bilateral lending relationships: Active engagement with borrowers improves the success of workouts and increases recovery rates.
While these factors make sense in theory, the case for private credit remains untested. However, there is one segment of private credit that has been around for a longer period: business development companies (BDCs). BDCs now account for a significant portion of assets under management in private credit, making them potential indicators of the future direction of private credit.
At its core, a BDC is a tax-efficient investment vehicle established in the 1980s to provide funding to middle-market companies that lack access to capital markets. BDCs must invest a majority of their assets in private US companies or smaller public ones, maintain a moderate debt-to-equity ratio, and distribute 90% of taxable income as dividends. In return, they pay no corporate tax. BDCs operate as closed-end funds, meaning that after raising capital through share issuances, the shares can be traded among investors without contributing new capital to the fund. However, BDCs have now become a way to finance middle-market leveraged buyouts, with 80% of transactions involving private equity-sponsored businesses.
BDCs have experienced significant growth in recent years, largely due to the success of Blackstone’s Bcred. In just two years, Bcred has grown from zero assets under management to $48 billion, making it the largest BDC. Blackstone achieved this by introducing a new “perpetually non-traded” BDC structure that allows for the issuance of private shares without concerns about discounts in public markets. While this structure limits liquidity, Bcred offers attractive 11% distribution yields, which many investors find appealing.
Historically, some BDCs have delivered near-equity-like returns from fixed-income investments, a promise also made by many private credit funds today. Despite the S&P 500 outperforming BDCs in the past decade, these funds still managed to compound returns at an impressive 7% per year, surpassing typical high-yield bond funds or bank loan ETFs. It’s essential to note that within the BDC index, there is a wide range of performance, as not all BDCs have sustained positive track records.
The best-performing BDCs have achieved these returns while paying what some credit investors describe as “outrageous” fees to their managers. Asset managers running BDCs earn fees based on assets under management and investment income, which can be comparable to hedge fund fees. However, Blackstone’s Bcred has attracted clients by offering lower fees and has significantly grown its assets as a result.
Considering the strong track records of well-managed BDCs over the past decade, there is promise for what the best private credit firms can achieve in the future. These firms have more of the “special sauce” that sets private credit apart, such as lending to needier borrowers, tighter contracts, limited mark-to-market, and bilateral relationships. However, it’s important to note that BDCs established their track records during a period of low defaults and low rates. It remains to be seen how middle-market leveraged lending, whether through BDCs or private credit funds, will perform in an environment of higher rates and increased defaults.
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