This year, higher interest rates and the specter of slowing economic growth have strained rated corporate issuers, particularly those at the low end of the scale--rated 'B-' and below. These challenges are not unique to rated issuers, rather they're confronting all borrowers, including those funded by private credit.

The private credit market provides borrowers (typically unrated) with loans that are not publicly traded. Little information is available publicly on these borrowers, which are often private, unrated companies with debt that is not publicly traded on a secondary market. By contrast, more financial and secondary market data is available on the issuers of high-yield bonds and broadly syndicated leveraged loans.

Business development companies (BDCs) provide a source of funding to the private credit market, so their public filings offer insights into this market. BDCs were created in the U.S. by an act of Congress in 1980 to provide capital to small and medium-size borrowers. One requirement is that they must file quarterly updates on their asset holdings--which are mostly loans to private companies.

We've assessed these public filings from more than 150 BDCs (including publicly traded and nontraded). For this report, we've also included interval funds alongside BDCs, since interval funds are another growing source of private credit funding.

With close to $300 billion in assets, BDCs provide an important source of private credit funding, alongside middle-market CLOs and private credit funds. Of the BDCs that we assessed, loans account for about $244 billion of assets, or 84% of BDC assets (see chart 1). These loans include both broadly syndicated and private credit, with private credit accounting for over two-thirds of the loan portfolio. For the purpose of this report, we consider loans that are not broadly syndicated as private credit loans. These private credit loans are commonly negotiated directly between the lender and the borrower, where the direct lender is a nonbank financial institution.

BDCs' assets have expanded rapidly in recent years, along with the growth of the private credit market. The value of BDC asset portfolios is up 22% over the past year (to $292 billion in first-quarter 2023), and private credit assets account for most of the growth (see chart 2).

Capital flows even continued to flow into BDCs in 2022 and early 2023 as investors rebalanced portfolios. While other credit asset classes experienced outflows alongside the rapid escalation in interest rates, investors have added to private credit allocations, reshuffling exposures for a higher-for-longer rate environment.

Chart 1

Chart 2

Non-Traded BDCs Show Faster Growth Over The Past Year

BDCs have increased both in number and size over the past year. In particular, the number is up 9% between the first quarters of 2022 and 2023, and the average size increased by just over 11% (to nearly $2.48 billion).

The underlying average EBITDA of borrowers held by BDCs is also increasing as larger BDCs have the ability to be the sole lender to larger borrowers or, in some instances, to do a club deal with other BDCs. The rise of non-traded BDCs accounts for much of this growth (see chart 3). One such example is Blackstone's Private Credit Fund, which was established just in 2021 and is the largest perpetual, non-traded BDC with nearly $50 billion in assets.

While a publicly traded BDC is a closed-end investment company that trades on an exchange, a perpetual, non-traded BDC is structured more like an open-ended fund that allows quarterly redemptions (subject to a 5% limit). In either case, BDCs invest at least 70% of their assets in private companies, typically small and middle-market companies.

Alongside BDCs, we include interval fund assets in our analysis. While BDCs report their holdings quarterly, interval funds are only required to file updates every six months. An interval fund is a non-traded closed-end fund that offers to repurchase a set percentage of outstanding shares periodically.

Over the past few years, asset managers have launched additional BDCs, which are generally non-traded, to add to their direct lending platforms. Loan assets of non-traded BDCs rose 41% to $119.9 billion, and interval funds rose by 36% (to $10.3 billion). Over the same period, loan assets of publicly traded BDCs grew by a more modest 4% (to $114 billion). Loan assets of non-traded BDCs now exceed those of publicly traded BDCs.

These newer non-traded vehicles can take on larger hold sizes than publicly traded BDCs because the non-traded BDCs are flush with capacity from freshly raised equity commitments. By contrast, publicly traded BDCs are limited in their ability to raise equity when they trade below book value.

This extra capacity has contributed to non-traded BDCs and interval funds expanding faster than publicly traded BDCs. But as BDCs deploy larger sums of money to each investment, it could create concentration and vintage risk, especially for BDCs that have grown significantly over the last few years.

Chart 3

With loan sizes increasing, private credit loans were increasingly held by multiple BDCs over the past year. The share of private credit loans held by one BDC declined by four percentage points to 59% in the first quarter of 2023. For broadly syndicated loans, the share that's held by only one BDC is just 52%. More specifically, for private credit loans, 37% were held by two to five BDCs, and 4% by more than five BDCs. Among broadly syndicated loans, 41% were held by two to five BDCs, and 7% by more than five BDCs.

Private Borrowers Appear To Be Buying Time For Upcoming Maturities

Over the past year, speculative-grade-rated issuers have made progress in reducing near-term maturities despite the rising cost of capital in primary markets. Within BDC portfolios, we see a similar reduction in near-term maturities for private credit borrowers.

Over the past year, private credit borrowers (with loans held by BDCs) appear to have pushed out their maturity wall to later years. While the amount of these loans maturing through 2025 has declined, the amount maturing in 2026 and after has increased over the past year (see chart 4).

For smaller, more highly leveraged borrowers, such as those whose loans are held by BDCs, sources of debt funding can be limited. When financing conditions in primary markets for broadly syndicated loans and speculative-grade bonds turn more risk-averse, borrowers may have few options other than private credit. Thankfully for these borrowers, the increase in private credit investments, such as through BDCs, appears to be adding available funding into the market.

Chart 4

While borrowers' recent refinancing and new issuance is helping to buy time for debt maturities, this stands to add to funding pressure in coming years as the interest rate remains higher for longer.

For instance, maturities of loans held by BDCs now reach a peak in 2028, when nearly a quarter of private credit loans are scheduled to mature. Furthermore, the amount of debt maturing in 2028 has risen over the past year with companies taking new loans and refinancing existing debt.

This peak in the upcoming maturities mirrors what we've seen for rated speculative-grade debt in the U.S., which is also scheduled to peak in 2028 when a wave of pandemic-era debt issued in 2020 and 2021 comes due. Furthermore, among rated issuers, we've observed that recent issuance to refinance near-term maturities has added to maturities totals in 2028 and after.

LIBOR Transition Is Moving Ahead

While the transition away from LIBOR (the base rate in private credit loans held by BDCs) still has a ways to go, it has progressed rapidly over the past year. As of first-quarter 2023, the majority of these private credit loans referenced SOFR (at 54%), up from just 6% a year earlier (see chart 5). This progress is notable considering that LIBOR-based loans still accounted for nearly 90% of the loans in BDC portfolios back in first-quarter 2022.

Chart 5

Funding Comes At A Higher Price

Borrowers of all stripes face higher debt funding costs as the Federal Reserve has aggressively raised rates since the beginning of 2022. These rate hikes lifted the federal funds rate by 425 basis points from the beginning of 2022 to the beginning of 2023, and yields on loans held by BDCs had a comparable increase over this period. However, the pace of increase appeared to slow after fourth-quarter 2022.

While yields are up across the board, the increase has been less pronounced for private credit assets. Among BDC assets, yields on broadly syndicated loans averaged 9.9% in the first quarter of 2023 (up nearly 400 basis points over the past year). For private credit loans, yields averaged 10.7% (a slightly lower increase near 350 basis points).

While yields on private credit loans are higher than those on broadly syndicated loans, the gap has narrowed over the past year. To some extent, this likely reflects the increased flow of investment into private credit, leading to a larger supply of funding for direct lending. But narrowing yields could also reflect the changing composition of private credit borrowers.

With BDCs and other private credit lenders extending credit to larger borrowers, more multibillion dollar direct lending deals have happened. While fund size and equity commitments are part of this trend, another factor has been exemptive relief, which allows asset managers to deploy capital across more than one vehicle within their credit platforms. Meanwhile, the growth of club deals (involving a small group of lenders) also allows BDCs to be part of larger direct lending deals.

With such mega-deals, private credit has been able to provide funding for borrowers that are larger than what was conceivable in previous years. In the BDC portfolios, the average lending per borrower has increased by 11% over the past year (to $48 million).

Chart 6

Private Credit Demand Grows Despite Headwinds At The Low End Of Credit

We've observed elevated numbers of downgrades and defaults so far this year among issuers rated 'B-' and lower, particularly those whose credit fundamentals deteriorated in response to higher interest expense, tough financing conditions, and uncertain economic growth. Although we have a more limited view into the credit fundamentals of unrated private borrowers, these borrowers would not be immune to such challenges.

We may glean some further insight into the challenges these borrowers face through the portfolio of rated BDCs. S&P Global Ratings currently rates 11 of the largest BDCs, and these represent about 45% of BDCs' assets as of June 30, 2023.

Based on the rated BDCs, we expect the newly created BDCs to report minimal nonaccruals for now, but as they go through the credit cycle, we expect this ratio to rise. For more seasoned BDC portfolios, we have seen the weighted average interest coverage ratio decline, nonaccruals gradually rise, and payment-in-kind income increase as a percentage of BDCs' total investment income. Together, these point to further potential deterioration of asset quality.

We've noticed divergences among borrowers and investors as they adjust to the current environment. For instance, even though issuance of broadly syndicated loans remains hampered, investor flows into private credit and BDCs provide an alternative avenue of funding for borrowers. Borrowers are making some progress in reducing near-term maturities by tapping available funding to refinance. And while funding costs are up, the pace of increase has slowed as the Fed nears the end of its rate hike cycle.

While macro headwinds remain, recent data from BDCs shows signs that borrowers may be finding ways to weather the storm.

Related Research

• Global Refinancing--Progress Made As Pressure Remains, July 25, 2023
• Private Lending: Time to Adjust the Sails, April 18, 2023