No Cockroaches, No Unicorns: Private Credit Beyond The Headlines - The Cestrian Circle Newsletter
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Reality vs. The Headlines In Private Credit
by Mark Bloom, Convivo Income Opportunities
Private credit has been in the headlines lately, from “cockroaches” to “SaaSpocalypse”, to “investors flee”. I thought it would be useful to take a more nuanced look at what private credit actually is and how these headline issues actually relate to it, since, as we’ve seen in the Convivo portfolio, the headlines have affected our BDC holdings.
What Is Private Credit?
Let’s start with a basic definition. The kind of private credit we’re talking about here is simply an investment fund run by an asset manager that takes money from high net worth individuals and advertises that it will get them a better return than they could get by investing in publicly traded funds on their own. In return there are limits (and this is important for our discussion) on how much the investors can redeem from the fund, usually 5% a quarter. So the math works out to a five-year commitment before an investor can redeem all of their money from the fund.
That brings us to our first main point: the difference between liquidity risk and credit risk. Liquidity risk can affect any asset holder, whether it has underlying credit problems or not—think Silicon Valley Bank a few years ago, where a fast run on the bank’s assets caused it to fail. This was a psychological problem, not a credit problem—the herd in Silicon Valley all wanted their money out at the same time and the bank couldn’t round up enough money to honor the withdrawals, so it had to close. There wasn’t a proven case that the loans the bank held were failing, but the generalized fear was enough to trigger a liquidity crisis.
A similar situation can happen to a private credit fund. If for some reason the investors want their money back faster than the 5% a quarter limit the fund is in a no-win situation. Take OBDC2, a private BDC run by Blue Owl, which also runs the publicly-traded BDC OBDC. Last fall they wanted to merge the private OBDC2 into the public OBDC, (and this was always the plan, as OBDC2 was a drawdown fund, with a defined ending date), but there was a problem—at the time OBDC was trading 20% below its NAV, so OBDC2 shareholders would have taken a 20% haircut on their shares converting 1:1 into OBDC. The investors revolted and made a big enough stink that the public heard that the private BDC “was in trouble”. But again, this was a liquidity problem, not a credit problem—as this played out and the optics got worse Blue Owl decided to sell some assets from both OBDC and OBDC2 to raise enough capital to redeem about 1/3 of all the investors’ money to get out from under the headlines, and they suspended the merger plans.
One can find a lot to criticize in how Blue Owl handled the whole thing—couldn’t they have just given the OBDC2 investors a 20% bump in the share conversion to make up for the discounted OBDC shares?--but one thing you can’t say is that a private credit fund was failing and the investors wanted out. They suffered a confidence crisis, which turned into a liquidity crisis, but the underlying book of loans was performing.
(A point that some writers have made is that some of the PE investors wanting to redeem more than the allowed 5% may want to be bought out at 100% of NAV and then re-buy the same, or similar, assets in the asset manager’s public BDC at the current 80% to NAV share price—so getting a 20% discount on the assets. If so, full marks to them for playing the system well!)
Are Private Credit Loans Valued Correctly?
That brings us to our second point. “Mark to market” is the term for how private credit funds value their loans. Since private credit markets to richer, more sophisticated investors the rules they have to play by are a lot looser than the ones that publicly traded funds follow. Unlike public BDCs private credit funds don’t have to put out quarterly reports on non-accruals, NAV changes, and so on. Thus the “opaque” word used so often to describe private credit. The deal really is “hand us your money, we’ll make you the return we promised, we get to keep your money for at least five years, and don’t ask too many questions”. Which begs the question, are their loans marked accurately?
In the OBDC2 case, when assets were sold to raise funds for investor redemptions, the sale prices were at 99.7% of the marked value. So one of three things happened: either OBDC and OBDC2 were accurately marking the loans; or they cherry-picked only the cream of the book to sell, and those were accurately marked, where lesser loans on the book might not be; or they colluded with the buyers to transfer the loans to the buyers’ books for the marked amounts and they’ll quietly make it up to the buyers at a later point. The last one seems pretty unlikely, but I’ve heard people making the case for the middle possibility. My personal view is that Blue Owl and OBDC are solid citizens, so I think the OBDC book, at least, is accurately marked throughout as a public BDC and the CEO’s account of how they handled the crisis is true.
But the mark to market issue is front and center for loans to software companies, since everyone “knows” that AI is going to disrupt at best, and decimate at worst, most if not all software. My focus as manager of the Convivo Income Opportunities channel is the public BDC sector, which has been hard-hit by these fears: are the BDC’s loans to software companies accurately marked to reflect AI changes? This question has been front and center in the last couple of quarters’ earnings calls.
Let’s take a couple of the answers from the BDC CEOs. First, BDCs are essentially short-term high-yield loan funds, as most of their loans are for only two or three year periods. So a BDC loan book as it exists today may look nothing like one in three years’ time; if a BDC needs to pivot out of tech or to pick from the “winners” of AI disruption (and there will be many winners and losers, as in every change) they have the means to do that. Second, the BDCs that loan to tech say that they have been dealing with this question with their clients for a couple of years already, try to pick the software firms that are the most resistant to AI disruption, and are already managing for this problem. A company like Hercules Capital, a major late-stage VC lender, is entrenched in Silicon Valley, so they deal with AI disruption in the same time frame as their clients. Sure, they, along with everyone else, could be surprised at the pace of AI adoption and disruption, but it’s hard to believe that retail investors selling off good companies on future fears know more than the people in the room.
Current results for my BDC portfolio, which is detailed in the Convivo Income Opportunities service, backs this up, as we saw uniformly good results in all of our Q4 earnings reports—especially in the one most tech-heavy, Hercules Capital! That could change going forward, of course, but at this point it looks like the market has oversold our BDCs compared to their actual strength.
Will AI Kill Private Credit?
The AI issue is also front and center for private capital and banking. JP Morgan recently raised some eyebrows by preemptively cutting the lines of credit for its software borrowers—in other words, saying to them “you are worth less than you think”, or how they mark, their business. Observers said this was the first time they can remember a lender doing this before a borrower had missed any payments. So it’s a major statement from JPM that software tech is overstating its worth. Time will tell if doing this was prescient or just another move from Jamie Dimon, who three years ago was looking enviously at BDC performance and trying like so many other banks to get into the private credit business, before starting a lot of ruckus with his “cockroaches” comments about it.
Personally I take the middle ground about how “real” loan marks are. I think there will be plenty of private credit funds that get caught out marking their loans too high, that’s just human nature in an under-regulated business. There will probably be some of the worse BDCs doing the same thing. We just saw BlackRock’s BDC, TCPC, get caught having to reduce its NAV by a huge amount in one quarter by having to re-mark a big chunk of its loan book. TCPC has always been a poor BDC, so this wasn’t a huge surprise. But I feel confident that the good players in the BDC field value their history and reputations and practice good marking on their loans. They report every quarter on their entire loan book, with loans going on and off non-accrual status with both at cost and fair value figures, realized and unrealized gains and losses from the loans, and internal rankings of their loans, all available to the public. This is the opposite of the “opaque” description of private credit.
At times you can see how different BDCs handle loan marks when different BDCs lend to the same company. There was a famous case a few years ago when the loans to Pluralsight went bad. The better BDCs like ARCC had small exposure of less than 1% to Pluralsight and had the loans marked much lower before it went into non-accrual; the worse BDCs like OCSL had bigger positions (5% of its loan book for OCSL, which is nuts) and had the loan marked in the 90% range, which turned out to be nowhere near reality. Cases like that tell investors which BDCs are marking accurately and which aren’t—and it certainly got me to exit OCSL before it really went south!
When investing my own money, which I share in detail with Convivo subscribers, I try to choose BDCs that mark accurately and conservatively. They can be aggressive players in their fields, like TRIN and HTGC, or solid SWANs like ARCC, but they still use good numbers in their earnings statements.
Is It A Good Time To Buy Into Private Credit?
Right now we’re seeing a tough time for BDCs, with many down 20% from their highs last fall. Back then the worry was that declining interest rates would lead to dividend cuts. Then we had the OBDC2/private credit is failing saga. Then the AI will kill all software (and thus also their lenders) story. Now the Iran war that will drag on and bring stagflation for the worst of all cases. All of that is beyond my pay grade. Whether this is justified time will tell. But if you like class A BDCs either they are as attractively priced as I can remember or the market has (correctly or not) repriced them on sentiment rather than numbers. Usually when that happens that means there’s money to be made. That argues for buying, or at the least holding and collecting the higher yields from the cheaper prices, as I’m doing.
This article was first published in the Convivo Income Opportunities channel for subscribers. CIO runs a model portfolio of income holdings designed for yield and occasional capital gain opportunities. All opinions here are solely those of Mark Bloom, the Convivo manager. Convivo’s introductory pricing is in effect until April 13, at which point prices will rise substantially. Subscribe this week to lock in the current low prices for as long as you remain a member. We never raise prices for existing subscribers.