Evening Brief – 05.16.23

Given we are arguably in a credit crunch, two sectors that stand to benefit are private credit and business development companies, or BDCs. Private credit pools have been around for a while but are gaining widespread popularity amid the regional banking crisis and the attractive returns now offered with higher interest rates.

Like REITs, BDCs are regulated firms in that they must distribute 90% of their net investment income. They are a desirable asset class that offers rates comparable to private credit pools and may also be hedged using leverage and derivatives. A well-run BDC’s portfolio will have the majority of loans structured as senior secured debt.

BDCs provide mostly floating-rate loans that generally pay 5%-7% over the Secured Overnight Financing Rate (SOFR), currently around 5%, thus generating returns of 10%-12%.

These private transactions are negotiated directly between the lender and sponsor/borrower, with a focus on extensive due diligence. Private lenders seek to negotiate strong structural protections, including covenants and higher call premiums. Borrowers seek certainty of terms, flexible structures and a more efficient process than the public market.

There are two ways to get in: either buying shares of stock in publicly-traded private equity firms – with all the exposure to the troubled commercial real estate markets – or buying shares in carefully-researched BDCs that use public markets to sell shares.

The dividend distributions, which currently range between 10% and 13% on average and equal returns of private credit pools, are what make BDCs so alluring.

If the historical return for the S&P500 is around 10%, then in the current market environment it would make sense to own some assets whose dividend income corresponds to the S&P’s past, and potentially future, performance.