For the first time since a war of words erupted over the risks in private credit in the wake of high-profile collapses, investors are getting hard figures on the state of the $1.7 trillion debt market.
And the results coming in from quarterly earnings of business development companies — a popular publicly traded structure for pooling direct loans — point to a softening market.
Blue Owl Capital Corp. reeled in $190.1 million of net investment income in the third quarter, missing average analyst estimates, according to data compiled by Bloomberg. Ares Capital Corp. also missed estimates, bringing in $338 million of net investment income.
Sixth Street Specialty Lending Inc. beat estimates with about $50.7 million of adjusted profit in the quarter, Bloomberg-compiled data show. Since Tuesday morning, before the BDC released earnings, its shares have dropped about 5% through 12:38 pm in New York.
Shares of BDCs have taken a hit in recent months as investors have become increasingly concerned private credit is set to produce lower returns on the heels of rate cuts and spread compression. Some are also scrutinizing the market for signs of stress, like rising defaults.
“The global wealth community has spent the past four years allocating tens of billions of dollars annually into the upper-middle market in direct lending, and for good reason,” said Dave Donahoo, head of US wealth management alternatives at Franklin Templeton.
“They saw a yield premium, stability, and an attractive risk-return profile,” he said. “But now, that same community is saying it’s gotten a little crowded.”
Investors are looking for long-term reassurance, but some managers have urged them to adjust their expectations.
Sixth Street Partners Co-Chief Investment Officer Josh Easterly warned that private credit returns across the industry won’t look like what they have over the past few years, given the anticipated rate cuts.
“We were flummoxed that some in the industry have publicly thrown up their hands recently at how, in their view, BDCs have not been trading consistent with credit quality,” Easterly wrote in an investor letter on Nov. 4. Investors also care about earning a fund’s cost of capital, he added.
In a report this week, Fitch Ratings said its outlook for the BDC sector is “deteriorating,” given the expected rate cuts and elevated levels of income from payment-in-kind arrangements, which allow borrowers to defer interest.
Most deals added to non-accrual lists, which often means the borrower can’t currently make interest payments, in the third quarter were tied to loans for consumer-facing businesses. The Carlyle BDC placed Roomba manufacturer iRobot Corp. on non-accrual status after the company amended its credit agreement for the sixth time in August.
For the Blue Owl BDC, loans to online health insurance marketplace GoHealth Inc. and hair extension supplier Beauty Industry Group were placed on non-accrual. That brought the fund’s total to 1.3% of its portfolio in the third quarter, almost double the prior period. FS KKR took control of live-event company Production Resource Group, following an October restructuring.
While profit levels are set to decline from “recent highs,” FS KKR Chief Executive Officer Michael Forman said Thursday on an earnings call for the BDC, these funds are set up to keep providing attractive income streams for investors.
Rate cuts will also help borrowers, as their loan costs will come down, and should help grease the wheels for mergers and acquisitions to go ahead, Forman said.
Logan Nicholson, president of Blue Owl Capital Corp., said on Thursday that lower net investment incomes were “just a function of rates,” which have been the “primary driver” of earnings.
On earnings calls, private credit executives have also been trying to distance the asset class from recent collapses that have spooked investors, including First Brands Group and Tricolor Holdings.
First Brands was mentioned four times on an earnings call for Ares Management Corp.’s publicly traded business development company, Ares Capital Corp., despite the fact that the lender has never done business with the bankrupt company. Executives for Carlyle Secured Lending Inc. and FS KKR Capital Corp. also kicked off earnings calls saying they had no exposure to First Brands or Tricolor.
On a call last week for Blue Owl Capital Inc., the general partner of the BDC, Co-Chief Executive Officer Marc Lipschultz tried to set the record straight: The blow-ups were not indicative of widespread stress within private credit.
“This is like the Mandela effect of finance, which is this just common population, collective mis-impression of what’s going on,” Lipschultz said. It’s like thinking the Monopoly guy has a monocle, or Pikachu’s tail being black, though neither are true, he said.
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