Popularity of BDCs may lead to “style drift”, warns Barings
The rise of business development companies (BDCs) in the US is leading to a “style drift” that may expose private credit investors to more risks, according to Barings.
An analysis by Joe Mazzoli, head of investor relations and client development at Barings BDC, noted the increased democratisation of private credit in recent years, enabled in large part by BDCs.
He argues that their growing popularity – and the speed of capital raise required – has made it more challenging for some managers to generate a sufficient number of quality deals to satisfy demand, leading them to include more broadly syndicated loans within their vehicles, or large corporate/mega cap private loans that more closely resemble public loans.
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Broadly syndicated loans tend to result in lower returns as they are more liquid, meaning that increasing the exposure of BDC portfolios to these types of loans can dampen overall performance, Mazzoli added.
“For instance, whereas pure-play private credit BDCs have historically offered a low double-digit return profile, returns for BDCs that rely heavily on broadly syndicated or mega cap private credit loans may more likely be in the high single digits,” he said.
Additionally, public loan exposure adds public market volatility to the portfolio, which can be unattractive for investors that chose to diversify into an illiquid asset class to avoid the effects of market volatility.
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The other issue cited by Mazzoli is documentation. Broadly syndicated loans tend to have less robust structural protections like financial maintenance covenants, unlike private credit middle-market loans that typically include them.
“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,” he said. “While benign environments like we have been in more recently can leave investors less focused on the benefits of conservative documentation, at the end of the day – and when the tide goes out – financial maintenance covenants and structural protections really matter.”
Mazzoli’s comments echo those of Oaktree’s co-chief executive and head of performing credit Armen Panossian, who warned that BDCs have “materially increased” the risks around private credit.
