More pain ahead for public BDCs

PRIVATE credit’s aggressive push to court retail investors has exposed the industry to a less familiar threat: public market volatility, which is dragging business development company (BDC) shares toward their steepest discounts relative to their assets since the pandemic.

A string of publicly-traded BDCs have posted earnings over the past month – the first since a number of private BDC vehicles faced a wave of redemptions.

And the data are stark: credit losses are climbing, new lending is falling and portfolios are shrinking. 

Valuations have declined in recent weeks, with the firms’ shares trading at an average of around 85% of their net asset value (NAV), based on averages for the S&P BDC Index.

A ratio that low can signal fears of more pain ahead.

Blue Owl Capital Corp and Sixth Street Specialty Lending both reported a loss during the quarter, while Carlyle Secured Lending and FS KKR Capital Corp reduced their dividend payouts.

Executives at BDCs say the best times are still to come and that a saner lending environment is creating opportunities to earn better returns on new loans.

But investors have been fearful about credit losses for months, with the ratio of price-to-NAV having fallen sharply over the last year.

“We expect to see even further deterioration from here for certain BDCs,” Chelsea Richardson, a senior director at Fitch Ratings, say in an interview.

“We have seen continued pressure on net investment income, which we expected with December rate cuts flowing through, as well as more dividend cuts, NAV declines, and upticks in leverage for the sector.”

The firms’ shares traded in the first quarter (1Q) at their steepest discount to NAV since 2020. That’s based on a Bloomberg comparison of share prices at the end of the period against NAVs for that period that were reported weeks later.

For years, private credit executives have pitched a seductive narrative: their portfolios of directly negotiated loans are largely insulated from the market shocks that send stocks and bonds tumbling. 

But the economic toll of higher-for-longer interest rates has squeezed the cash flows of mid-market borrowers while the rapid rise of artificial intelligence has hurt the outlook for some software sector loans.

At FS KKR, the fund’s share of non-accruals – or loans that no longer pay interest – rise to 4.2% of the portfolio’s fair value. Investments with that designation climb to 4.7% of Goldman Sachs BDC Inc’s portfolio at cost, it says.

Ares Management Corp write down the value of loans to three Clearlake Capital Group-owned software businesses, which are the largest contributors to the fund’s US$357mil of net unrealised losses.

Because BDCs must revalue portfolios to market conditions each quarter, broader volatility forces technical markdowns on loans that continue to perform and pay interest. 

At Sixth Street, for instance, the main driver – or nearly 80% – of its BDC’s NAV per share decline is “attributable to the movement in fair value from the market inputs, which are unrealised”, Bo Stanley, chief executive officer of Sixth Street Specialty Lending, says on an earnings call.

“These results reflect a period of market-driven volatility rather than a change in the underlying strength of our business,” Stanley says. “We are well-positioned to capitalise on opportunities as the market continues to evolve.”

The macro anxieties have trickled into all corners of the retail channel, prompting investors to pull cash from non-traded private credit funds.

For the first time, these vehicles hand more money back to investors via redemptions than they raised in the 1Q, according to a report from Robert A Stanger & Co.

Managers have found a silver lining to the slowdown. Tapering retail inflows have improved the market’s supply-demand dynamics, according to Blue Owl Capital Inc co-president Craig Packer, creating what he calls a “more favourable” landscape for deals, with better premiums and terms.

“We believe this is a more attractive investment environment than the one we’ve been operating in over the last two years,” Packer says.

The firm’s largest publicly traded private credit fund, Blue Owl Capital Corp, is well positioned to take advantage of that, he adds. 

Other managers of private credit funds also predict a rebound as market pressures moderate.

“We expect these unrealised losses related to credit spread movement to reverse over time as market conditions change and our investments approach realisation or maturity,” Stanley says.

Divergent rhetoric

But despite the sanguine commentary, Citigroup Inc analysts caution there are signs the market is preparing for stress, such as the growth of secondary market funds to acquire discounted assets and new CDS hedging tools.

These “point to a divergence between market rhetoric and the actions of sophisticated investors”, they write in a recent note. 

“Managers frame the recent selloff not as a sign of stress, but as an opportunity to commit capital,” the analysts add. 

Managers have also been eager to show their commitment to supporting their vehicles, with measures ranging from share buybacks and fee waivers to direct capital injections.

KKR says it will invest US$300mil into the BDC it manages with Future Standard in the form of preferred equity and share tenders. 

The BDC’s board of directors have also authorised a US$300mil share repurchase programme that will run for about a year, and KKR has agreed to waive its portion of incentive fees for four quarters. 

Some BDCs have been able to tap debt markets, in a sign some anxiety is abating. Blue Owl Capital Corp raised US$400mil from bond investors last month, marking the first deal of its kind in over a month and sparking a wave of subsequent issuances from rival funds.

“For the sector as a whole, we expect the outlook for dividend coverage to improve,” Fitch’s Richardson says. “But we do expect some specific BDCs to have further incremental pressure.” — Bloomberg