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 made possible to a large extent by the emergence of investment fund structures such as business development companies. There are several different types of BDC structures, and when determining how to enter the market, investor preferences about liquidity and share price volatility play an important role:
- Public BDCs are those that trade on public exchanges. They can provide investors with significant 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- Private BDCs resemble a withdrawal structure where an investor makes a commitment and that investment is withdrawn as a private fund. This structure tends to offer lower volatility than a public BDC, but has less liquidity since investors are limited in not being able to sell shares.
- Perpetual BDCs are fund structures that allow investors to access fully expanded and diversified portfolios with lower minimums, positioning them to earn quarterly (or monthly) cash dividends immediately.
The increasing prevalence of perpetual BDCs has been somewhat of a double-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 development” that can expose investors to unwanted risks.
Drift style
For perpetual BDCs raising capital beyond their opportunity pools, challenges can and do arise when it comes to deploying that capital in “true” middle market deals—typically defined as debt from companies with EBITDA between 15 and 75 million dollars. As a result, some managers may need to incorporate a greater portion of syndicated loans into their BDC portfolios or, in some cases, private large/mega cap loans that are more like public loans than private loans .
Overreliance on syndicated loans or private mega-cap loans can negatively impact performance in ways that investors may not anticipate. While the extent to which these loans impact performance depends on the amount of holdings, they generally offer lower spreads, do not involve financial covenants, and can bring the volatility of the public market into a private loan offering.
Returns
While past performance is not necessarily indicative of future results, one of the main attractions of private credit for many investors is the potential spread premium over public markets. This premium has traditionally been derived from the illiquid nature of the market, or the fact that there is no limited ability to sell from an asset during its typical five to seven year life cycle. Private loans also cannot be obtained from a bank trading desk. Rather, transactions must be locally sourced and privately negotiated.
In the broader syndicated loan market, investors can more easily sell off assets given the large and active secondary market. As a result, spreads – while sometimes compelling for investors seeking liquid market exposure – are typically narrower than in private credit. Ultimately, this could translate into lower returns than investors might expect from a private credit vehicle.
Instability
Public debt exposure also adds public market volatility to BDC portfolios. In general, investors seeking a private credit allocation are attracted by the potentially low volatility, low correlation with public markets and the diversification benefits of private markets. At times when investor sentiment shifts from risk to risk, for example, selling pressure in the syndicated loan market tends to reduce 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 make up a significant portion of a BDC portfolio may come as an unpleasant surprise.
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Joint loans generally lack strong structural protections such as financial maintenance agreements. In the core middle market, on the other hand, financial maintenance conventions still exist in almost all transactions. Financial maintenance agreements are a critical part of loss management in the illiquid private credit market. At their most basic, they give managers the ability to jump in early and influence the underlying business in the face of modest underperformance. If challenges arise, financial maintenance agreements also give lenders a seat at the negotiating table, giving them the opportunity to proactively help protect principal. In the context of a vehicle such as 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.
After all
The speed of capital raising by some permanent BDCs has made placing in true middle market transactions more challenging for some managers. As more managers are moving to the market in response – adding 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 background, it is essential that investors consider the manager they are partnering with and how that manager approaches portfolio construction.
Joseph Mazzoli, CFA, serves as Head of Investor Relations and Client Development for Barings BDC