Private credit has seen its investor base expand significantly in recent years to include a growing number of wealth channel participants. This democratization has been enabled in large part by the emergence of investment fund structures like business development companies. There are a few different types of BDC structures, and when determining how to access the market, investor preference around liquidity and stock price volatility play a significant role:
- Public BDCs are ones that trade on public stock exchanges. They can offer investors meaningful liquidity, but they also come with a high level of investment volatility because publicly traded stocks move up or down with the markets.
- Private BDCs resemble a drawdown structure where an investor makes a commitment, and that investment is drawn down like a private fund. This structure tends to offer lower volatility than a public BDC, but there is less liquidity as investors have limited to no ability to sell shares.
- Perpetual BDCs are fund structures that allow investors to step into fully ramped and diversified portfolios with lower minimums, positioning them to earn quarterly (or monthly) cash dividends right away.
The increasing prevalence of perpetual BDCs has been somewhat of a doubled-edged sword for managers. On the one hand, they have allowed more investors to access the potentially attractive yields, historically strong risk-adjusted returns, and low relative volatility characteristic of private credit. But their growing popularity has also made it more challenging for some managers to generate enough quality deals to satisfy demand—leading to a degree of “style drift” that can expose investors to unwanted risks.
Style Drift
For perpetual BDCs that raise capital beyond their opportunity sets, challenges can and do arise when it comes to deploying that capital into “true” middle market deals—typically defined as debt from companies with EBITDA between $15 and $75 million. As a result, some managers may have to incorporate a larger portion of broadly syndicated loans into their BDC portfolios or, in some cases, large corporate/mega cap private loans that more closely resemble public loans than private loans.
An overreliance on syndicated loans or mega cap private loans can negatively impact performance in ways that investors may not anticipate. While the degree to which these loans affect performance depends on the amount of the holdings, they generally offer lower spreads, do not include financial covenants, and can introduce public market volatility into a private credit offering.
Returns
While past performance is not necessarily indicative of future results, one of the key draws of private credit for many investors is the potential spread premium over public markets. This premium has traditionally stemmed from the market’s illiquid nature, or the fact that there is limited to no ability to sell out of an asset during its typical five-to-seven-year life cycle. Private loans also cannot be sourced from a bank trading desk. Rather, transactions must be locally originated and privately negotiated.
In the broadly syndicated loan market, investors can sell out of assets more readily given the large and active secondary market. As a result, spreads—while at times compelling for investors seeking liquid market exposure—are typically narrower than in private credit. Ultimately, this can translate into lower returns than investors may expect from a private credit vehicle.
Volatility
Public loan exposure also adds public market volatility to BDC portfolios. Generally, investors seeking a private credit allocation are drawn to the potentially low volatility, low correlation to public markets, and diversification benefits of private markets. At times when investor sentiment shifts from risk-on to risk-off, for instance, selling pressure in the syndicated loan market tends to depress the net asset value of BDC portfolios with large liquid loan holdings. For BDC investors who sought to avoid the effects of market volatility by choosing to invest in an illiquid asset class, this consequence of having liquid assets constitute a sizeable part of a BDC portfolio may come as an unpleasant surprise.
Documentation
Broadly syndicated loans generally lack robust structural protections like financial maintenance covenants. In the core middle market, on the other hand, financial maintenance covenants still exist in almost all transactions. Financial maintenance covenants are a critical part of managing losses in the illiquid private credit market. At the most basic, they give managers the ability to step in early and influence the underlying business in the event of modest underperformance. Should challenges arise, financial maintenance covenants also give lenders a seat at the negotiating table, allowing them the opportunity to proactively help protect principal. In the context of a vehicle like a perpetual BDC, the lack of robust protections can leave investors more vulnerable to downside risk that could impact recoveries—particularly in more challenging market environments.
The Bottom Line
The speed of capital being raised by some perpetual BDCs has made deploying into true middle market transactions more challenging for certain managers. As more managers are moving up-market in response—adding broadly syndicated loans and/or mega private credit deals to their portfolios—there are implications for investors in terms of both risk and return. Against this backdrop, it is critical for investors to consider the manager they are partnering with and how that manager approaches portfolio construction.
Joseph Mazzoli, CFA, serves as Head of Investor Relations & Client Development for Barings BDC