Investor demand for private credit has been strong over the past year. Many different types of funding vehicles that invest in private credit assets are seeing rapid growth, including business development companies (BDCs) and interval funds, along with middle market CLOs and private credit funds. Total assets of BDCs and interval funds climbed to $325 billion in the third quarter, up 11.7% over the past year. In total, there are about 140 BDCs (excluding interval funds). Approximately 50 of the BDCs are publicly traded, and these held about $130 billion in assets in the third quarter 2023 filings.

Much of the recent growth of BDCs has been spurred by launches of BDCs that do not trade on a secondary market (such as perpetual, nontraded BDCs), but rather are structured to provide liquidity to investors by allowing quarterly redemptions that are typically capped at 5% of net asset value. Over the 12 months through third-quarter 2023, asset growth of nontraded BDCs (at nearly 30%) outpaced that of publicly-traded BDCs (down 9%). With this growth, the assets of nontraded BDCs have now surpassed that of publicly-traded BDCs, reaching $158 billion in assets in the third quarter.

BDC growth provides an expanding base of demand for private credit because the majority of BDC assets are private credit loans to U.S.-based borrowers. Meanwhile, an interval fund is a nontraded closed-end fund that offers to repurchase a set percentage of outstanding shares periodically, and a considerable share of these funds' assets are allocated to private credit.

With their holdings of such assets, BDCs and interval funds provide a unique lens into the private credit market because they are required to disclose information about their asset portfolios through public filings. For this report, assessed these public filings to gain insights into the private credit market, where transparency is often lacking.

Nontraded BDCs Have Led Growth Of New BDC Formation

A nontraded BDC at inception is typically structured as either private, nontraded or perpetual, nontraded. For private, non-traded BDCs, it must contemplate a liquidity event in five to seven years. The liquidity event can be in form of a public listing or merging with another fund. Having said that, over the past two years, there has been substantial growth in private credit, particularly direct lending, which has led to a proliferation of BDCs as several asset managers have launched their own direct lending vehicles that are structured primarily as perpetual, nontraded vehicles. Rather than issuing equity through the stock market, these nontraded BDCs raise capital through unregistered equity offerings.

These new offerings have been met with substantial investor demand, with considerable demand from institutional, high-net-worth, and retail investors. Outside of a contemplated liquidity event, one of the key differences between a private and perpetual fund is the end investor. In a private, nontraded BDC, the investor base is generally institutional and high net-worth investors who generally have limited redemption needs during the private phase. In perpetual-life nontraded BDCs, investor liquidity is subject to the terms of share repurchase program (capped at 5% of net asset value [NAV] per quarter). Generally, the retail and high-net-worth individuals must hold the shares for at least one year to avoid a penalty of 2% of NAV for early redemption.

Investors in a publicly traded BDC include retail investors and high-net-worth investors, as well as institutional investors. For liquidity, the investor can sell these shares without any limitations or restrictions on a public exchange.

Chart 1

Nontraded BDCs are growing rapidly. Over the past two years, the total market of nontraded BDCs nearly tripled to almost $160 billion in assets in third-quarter 2023 from $54 billion in third-quarter 2021. During 2023 alone, the assets of nontraded BDCs rose by $36 billion as many new nontraded BDCs were formed.

Chart 2

BDC Assets Provide A Lens Into Private Credit

Private credit loans account for the majority of BDC assets. These assets are natural fit for BDCs, which were created in the U.S. by an act of Congress in 1980 to provide capital to small and midsize borrowers.

Loans (including broadly syndicated and private credit) account for the majority of BDC assets, at around 83%. More than two-thirds of the loans are private credit. Over the past year, the holdings of private credit assets have grown at a faster pace than either broadly syndicated loan or bond assets, even though all three have seen expansion. Meanwhile, equity holdings have grown at an even higher rate (up 21% to $38.4 billion), while private credit grew by 14% to $184.6 billion.

Building Liquidity

Even though investor redemptions from perpetual, nontraded BDCs are capped, BDC managers appear to have added to their holdings of more liquid assets, including broadly syndicated loans and high yield bonds, in third-quarter 2023. Unlike the largely illiquid, hold-to-maturity market for private credit, secondary trading markets for broadly syndicated loans and high-yield bonds provide a source of liquidity for a manager seeking to exit a position. Together, broadly syndicated loans and bonds accounted for 31% of BDC assets in third-quarter 2023, up by a percentage point from the prior quarter. This increase marked a shift as the share of liquid assets held by BDCs had been in a decline over the past few years with growing private credit exposure.

Chart 3

Borrowers Continue To Reduce Near-Term Maturities

Within the asset portfolios of BDCs, we see that borrowers have made progress reducing near-term maturities over the past year.

In the primary markets for speculative-grade bonds and broadly syndicated loans, issuance has been bustling in recent months, with refinancing and amend-to-extend deals accounting for much of the activity. Through recent refinancings and amend-to-extend deals, borrowers from the publicly traded markets have been able to make progress pushing near-term maturities back into later years.

Similarly, borrowers with private credit loans held by BDCs have also shown progress reducing near-term maturities over the last year. But as we've seen in the public credit markets, these recent refinancings are adding to the maturities coming due in 2028.

From third-quarter 2022 through third-quarter 2023, the amount of private credit loans maturing in 2024 fell by 31%, and those maturing in 2025 fell by 5%. However, as these near-term maturities have been reduced, the amount set to mature in 2028 has increased by 44%.

With this addition, private credit maturities are now set to peak in 2028, when $49.5 billion is set to come due.

While near-term maturities appear increasingly manageable for borrowers, the buildup of debt maturing in later years will put additional pressure on borrowers as they seek to refinance.

Issuers of broadly syndicated loans and speculative-grade bonds often return to the capital markets 12-18 months ahead of maturity to refinance debt, which means the pressure of these upcoming maturities will soon be felt.

By contrast, private credit borrowers may tend to wait until closer to maturity to refinance. This is typically the case when the borrower is working with a single direct lender because there is more certainty of deal execution.

Chart 4

High Funding Costs Are Starting To Moderate

Meanwhile, funding costs dipped slightly in the second half of 2023, with investors increasingly coming to the opinion that the Federal Reserve finished its current cycle of rate hikes in 2023 and will cut rates beginning in 2024.

With expectations mounting that rates may have already peaked, credit spreads began to tighten.

As a result, within BDC portfolios, the average yields of both broadly syndicated and private credit loans fell slightly in the third quarter. The average yield on a private credit loan fell by about 48 basis points (bps) to 10.3%, and the average yield on a broadly syndicated loan in the portfolio fell by about 76 bps to 9.2%.

This also marked a modest widening of the spread between broadly syndicated and private credit loans. At 10.3%, the average yield on a private credit loan was 105 basis points higher than a broadly syndicated one, and this is up from 76 bps in the prior quarter. However, even though the yield on a private credit loan rose relative to a broadly syndicated loan in the quarter, the difference in spread remains much narrower than it was two years ago.

Chart 5

While the narrowing of spreads between private credit and broadly syndicated loan over the past few years could reflect the increased amount of investor interest in (and capital inflows into) private credit, but it could also be the result of a change in the composition of private credit borrowers. As private credit lends to larger borrowers, yields on megadeals may be closer to those on offer to broadly syndicated borrowers than to smaller middle-market borrowers.

With more dry-powder available to lend, as well as with the rise of club deals (from a small group of lenders), and through exemptive relief (which allows asset managers to deploy capital across more than one vehicle within their credit platforms), direct lenders have been able to offer larger loans and private credit deals continue to grow.

With this shift, the size of the average size of a borrower (with loans held by a BDC) has been growing in the past few years. In third-quarter 2023, the average borrower size (with loans held by a BDC) was $49.6 million--up by around 40% since third-quarter 2021.

Chart 6

Rated BDCs Account For Nearly 50% Of BDC Assets

We rate a relatively small number of BDCs (with 13, see table 1 below), and these include many of the largest BDCs. Rated BDCs account for about $157 billion in assets, or about half the total of BDC assets. We rate all 13 BDCs 'BBB-', with 12 having stable outlooks and only one with a positive outlook. The current ratings and outlooks for these 13 BDCs are supported by low leverage, diversified funding mixes, granular investment portfolios, adequate liquidity to meet funding needs (debt maturities, unfunded commitments, redemption requests), cushion to regulatory asset coverage ratio, and affiliation with broader asset managers. (Note that our assessment of the public filings of BDCs for this report includes unrated, as well as rated, entities.)

Among the rated BDCs, we have seen credit tighten as higher interest rates and an economic slowdown has led to lower deal flow and reduced new capital deployment opportunities. While the market trends and valuation marks have been better than expected, due to the choppy macroeconomic environment we are in, we expect valuations to exhibit more volatility over the near term. The average EBITDA of the borrowers with debt held by BDCs has increased in recent periods, and borrowers with higher EBITDA should have a greater ability to cope with a potential economic slowdown than their smaller peers.

Having said that, the longer interest rates remain elevated and the higher inflation lingers, the more difficulty borrowers in certain sectors will have in passing rising costs to end users. Given the aggressive interest rate hikes in 2023 and their lagged impact, we anticipate that the interest coverage ratio will decline further as many borrowers have yet to feel the rate hikes' full impact. This could constrain their ability to service debt and increase the probability of default. While the underlying investments for BDCs lenders are illiquid, we believe that investments marked 80% or lower of cost have a higher likelihood of defaulting. At rated issuers, 5% of investments, on average, were marked 80% or lower as of September 2023.

Table 1

As some borrowers have struggled, we've seen BDCs actively amending some of the troubled credits by converting their cash interest payments to payment-in-kind (PIK). While this reduction in the demand for cash provides some relief to the borrower in the short run, over time we expect this to lead to higher underlying leverage of the borrower and interest coverage that remains pressured. Among the BDCs we rate, PIK income has been making up an increasing percentage of BDC's revenue from investments (sometimes as high as around 15%-20% of gross investment income).

Navigating Higher Rates

While BDC growth has continued apace, and borrowers have seen some benefit with maturities pushed-out to later years and funding costs showing a slight moderation, there remains a weakness within the credit portfolios. The decline in the interest coverage ratio coupled with an increase in PIK-revenue is a continued reminder that many borrowers continue to struggle to maintain cash flows while interest rates are at current levels. However, continued investment inflows into private credit add to the pool of capital available to help borrowers weather current challenges.

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