A window into private credit marks

Being a private-market fund manager seems like a pretty nice deal.

How does a manager deal with the challenge of marking highly illiquid paper? “Rigorously! But it’s a private market, so of course there’s always uncertainty.” How’s the market doing under the strain of higher rates? “Things are great with us! But it’s hard to say for certain that our competitors are holding up as well. It’s a private market after all.” And so on.

The privacy isn’t complete, however. Something that’s often forgotten is that an estimated 40 per cent of the private credit market’s invested assets are in vehicles that publicly report loan-level holdings and performance.

These vehicles are called business development corporations, or BDCs. They operate under the same US regulatory umbrella as real estate investment trusts, meaning they have to pay out 90 per cent of their earnings to shareholders.

They’ve been around since the 1980s and have been publicly traded for most of the industry’s history, but more recently managers have shifted into unlisted and perpetual-life BDCs (which still have to report quarterly).

Now, the loans held by BDCs aren’t priced often. And as we’ll see, their prices aren’t necessarily consistent. But they’re priced transparently, because BDCs publish the fair value of their loans each quarter.

This creates an opportunity for a fun little experiment. Some BDCs invest in the same deals, which means observers can compare and contrast the way different BDCs are marking the same loans.

If you ask a third-party analyst who does this type of valuation work, they will assure you they have a rigorous system to assign values to various loans, despite the illiquidity and opacity of the market. It helps that there is a very large market for broadly syndicated loans (not securities, mind you!) which is still opaque but trades semi-regularly (often via fax).

But the actual pricing shows significant room for disagreement. For example, Barclays notes that different BDCs have in recent years published a rather wide range of marks on the same senior Stamps.com loan maturing in 2028:

Whew!

What sticks out in the chart above is that the widest gaps in valuation were from 2022 on. Rising interest rates did (and still do) create challenges for the value of asset-light work-from-home business models like Stamps.com, but . . . are those questions really unanswerable? Is its outlook uncertain enough to explain a full four points’ difference in loan valuation?

At best, this casts serious doubt on the idea that anyone can measure a BDC’s quality by the performance of its loan book. (It’s usually better to study their distributions compared to their income anyway.)

At worst, it’s shows a central risk of private credit markets, and private markets in general: Too much creativity/optimism on loan valuations can leave investors holding junkier debt than they thought.

Barclays argues there’s another reason for caution: Most of the private credit invested today hasn’t seen a “true credit cycle”, the analysts say.

Private credit investors deployed a lot of cash into the vacuum of funding that hit during Covid shutdowns — which was obviously a good idea, everything was cheap! — but it will be interesting to see what happens to those loans if defaults continue to rise and credit performance deteriorates further.

There is one new-ish strain on BDCs from the broader market’s funding pressures: The rising share of loans that are paying their interest in-kind (eg with more debt) instead of cash.

The problem with PIK loans is that BDC payouts are based on income, and in-kind payments don’t generally count as earnings, according to Barclays.

So these types of payments leave the BDCs with a smaller pool of cash-generating assets, and all else equal less yield for shareholders:

With the growing prevalence of PIK utilization in private loans, BDCs’ proportion of PIK assets relative to income has increased according to multiple sources. This trend likely began with a rise in issuance of structured preferreds with PIK-only components post-COVID but has clearly continued in more standard structures today. It is also worth noting that the quantity of BDCs in the sample [highlighted in the chart above] has changed over time, as at least 20 have IPO’d since 2013. Nevertheless, it is a useful proxy for how PIKs have infiltrated BDC portfolios. 

This increase in PIK loans hasn’t hurt BDCs’ ability to cover their regular dividend payouts, however. Their dividend coverage is at all-time highs because the net interest income from their loans has outpaced the rise in payouts.

The median BDC’s annual dividend yield climbed to approx 11 per cent of NAV in the first half of last year, compared with about 9 per cent in the five years before Covid:

BDCs still face their requirement to distribute 90 per cent of their earnings, of course. But the chart above implies that some investors are willing to accept those returns in forms other than a regularly paid dividend. Or they could be comfortable with lower distributions (ie closer to the 90-per-cent minimum) than prior years.

That’s a bit odd, especially with fees, which no piece about BDCs can ignore. This handy fact sheet from 1Q23 puts the average BDC fee at nearly 5 per cent. These types of fees start looking a lot less attractive when an investor can log on to Treasury Direct for free to buy a two-year note yielding 4.4 per cent.

But hey — as long as there are BDCs out there, we have a nice and transparent little window into part of the fast-growing and heavily hyped market for private credit. So keep it up, we guess.

Further reading:

— Is private credit a systemic risk? (FTAV)

— Private credit returns are great — if you believe the marks (FTAV)