INTRODUCTION

Over at our sister publication – the BDC Credit Reporter – we have just written an article about our downgrade of Ivanti Software, a company with 11 BDC borrowers. Click here to read the article, which was made available to all readers as part of our regular out-reach program.

As we often do, we used the opportunity once we were done writing about the subject at hand to branch into a broader subject. In this case, we tackled a very broad matter indeed: the current state of credit conditions in the BDC sector. If that wasn’t enough, we also offered up our thoughts on how credit investors – whether in BDCs or any leveraged loan product – might get an early warning of a deteriorating U.S. credit environment.

We’ve not had a credit crisis since 2020, and that was quickly resolved by the Fed and the U.S. Government pumping up the economy in ways previously unimaginable. Otherwise, we have to reach back to 2008-2009 for the last truly serious economic and credit crisis. We were around for the Global Financial Crisis (GFC) and cannot adequately convey how terrible conditions were to anyone lucky enough not to have been impacted, and how hugely impacted were most BDC prices.

Like Gloria Gaynor, the BDC sector did survive and has gone from strength to strength since. However, every recession is different and has different consequences. For anyone invested in BDCs being properly prepared for the next “Big One” is important. We are lucky , in a way, because we’re in the right place to be forewarned, if we listen carefully. So without further ado, here are our thoughts on these important subjects. Our original article is slightly altered for clarity’s sake.

Primer

Over at the BDC Credit Reporter, we review every public BDC’s portfolio every quarter and seek to identify the most troubled borrowers. We use a scale of 1 to 5, where 1 relates to companies performing better than expected, 2 those performing as expected when underwritten, 3 modestly under-performing, 4 seriously underperforming and likely to result in a permanent loss and 5 reserved for non-accruals and more permanent losses. (This scale is not much different from what many BDCs publish in their quarterly filings). The focus of the Credit Reporter is principally on what we call the Important Underperformers – rated 4 or 5 and with a FMV of at least $5mn, which leaves out non-material companies which don’t move any needles. The Important Underperformers are those most likely to cause the biggest damage in terms of income and capital loss to the BDCs that have invested in them – and thus to their shareholders.

The Few. The Not So Proud.

After the addition of Ivanti today, we count 119 Important Underperformers in the BDC Credit Reporter’s database. We feel compelled to point out that 119 seriously troubled companies in a universe of 6,000-7,000 BDC-financed businesses is not that many. Even the dollars involved – $8bn at cost and $5bn at fair market value (i.e. with $3bn already written off BDC balance sheets) is modest in relation to the $388bn at cost and FMV of all BDC investments – as reported by Advantage Data/Solve. (Thanks to marked up equity investments, total BDC investment value are equal to their cost – which is a whole other story).

Imperfect

We concede that we may not have (yet) identified all Important Underperformers and some of the investments in the Solve numbers relate to BDCs involved only in equity investing and not in our coverage universe). Nonetheless, at a time when there is a lot of hand wringing about the relatively elevated level of bankruptcies and defaults in the leveraged loan market, the BDC data is relatively tame.

Quiet

Even more importantly – and we’re able to quantify this – the number of new Important Underperformers turning up in BDC portfolios is quite low.(Ivanti is an exception to this rule). More anecdotally, we also get the impression that the speed with which companies go from getting into trouble to being restructured and back to paying interest (typically rated rated 2 or 3) is accelerating. We put this down to how most failing companies get restructured in debt for equity swaps, as the lenders take control. The faster these restructurings can be fashioned the better the odds of the companies survival.

Don’t Under-Estimate

Despite all the negative talk in the financial press about how lenders are lumbered with weak or no covenants to protect their interests, they still have the tools to force these restructurings to happen, and in short order. Pluralsight was one huge example, but there have been many others in every segment of the market. Just look at “Control” and “Affiliate” investments in any BDC’s portfolio – designations they are required to show – and most of the companies listed will have found their way there due to lenders becoming owners.

Good News

All of this to say – for anyone interested – is that BDC credit conditions continue a multi-year trend of being favorable. The volume of companies and assets becoming non-performing and the realized losses that (almost) inevitably follow are what lenders – and their investors – should expect for lending to highly leveraged, non-investment grade companies from every corner of the economy – and thus vulnerable to all the ructions that occur in a dynamic capitalist economy. Some BDCs have even argued – in a form of “talking their book” – that credit results are above their historical average. In general terms, we’d say that’s true.

Uneven

There are two “howevers” , though, to mention. First, even in the sunniest times some individual BDCs are capable of getting rained on and we can name 12 BDCs in our 46 BDC universe who have been poured on in recent quarters. That’s why checking out the credit status of your favorite BDC is worthwhile and what we’re here to help you assess, both at the Credit Report and the BDC Reporter.

In A Flash

The second “however” is that the credit picture – like the weather – can change very quickly, especially for companies leveraged to the hilt – as they all are in this hyper-efficient environment. In 2008, conditions went from fair to foul – as we remember well even without the benefit of publishing the BDC Credit Reporter – in one to two quarters.

Give Us A Sign

We’ve been asked “when will we know that credit conditions are worsening across the board?“. This is the question credit investors seem to ask themselves all the time to be ready to be among the first to exit the building. (Whether that’s the right investment strategy is not for us to say, but you’ll see mini-examples of this rush to the exits in the here and now every time a particular BDC books a larger than expected number of troubled loans).

Here It Is

There is a simple answer. Look out for a material increase – 10%-20% – in the number of Important Underperformers and Watch List companies in the BDC Credit Reporter. Yes, we know that we now also may seem guilty of “talking our book”, but we have a reason for this advice beyond acquiring new subscribers.

Line Of Fire

The BDC sector is at the “tip of the spear” of the American economy – not the huge investment grade conglomerates which are the fodder of Bloomberg et.al. – and most of whom will tell you all is well as long as they can. It is among these smaller private and public businesses – most of which are not household names and do not have a PR department – that credit cracks will first begin to show. It is the BDCs – who receive monthly financial statements from these companies and are in constant dialogue with management – who will be alerted to the first signs of trouble. It is the BDCs – supported by a small army of “independent” valuation firms, who will be required to de-value their investments at the end of every quarter, lighting a beacon for those of us watching. There are a few BDCs who don’t seem to play fair where valuations are concerned but most – even if reluctantly – can be counted on to report the financial deterioration their companies might be experiencing.

What Disaster Looks Like

A Great Recession, or even a standard recession, will look like a tsunami – one long, continuous wave that looks small at first – not much different from every day waves – but grows ever larger and when it hits continues to push further and further forward. That’s because the early corporate casualties begin to affect companies that otherwise might have gone on as usual and that eventually feeds into everybody else – including the famous U.S. consumer on whose backs 70% of the American economy is carried.

Hope For The Best, Prepare For The Worst

We hope all of us will be spared any form of credit tsunami, but that’s unlikely if history is any guide. As you can imagine, the current re-making the global world order has raised the odds that the credit wheels might come off. In that regard, we are the most worried we’ve been since we heard word of a strange, deadly flu taking hold in China. However, these are the earliest days and although a dozen or more BDC managers have already been interrogated by anxious analysts in the last few days on their conference calls, none had anything much to report. We will remain vigilant and seek to alert our readers in all our publications to any change on the credit horizon.

Memory Lane

In a way, with BDC stock prices at or above post-Covid highs, we are more vulnerable than at any time in years. to a sudden downturn. We can’t help remembering – the blessing and the curse of longevity in this market – that the BDC sector was also at a high point in January 2007 after years of AUM and stock price growth, helped on by a strong economy. Two years followed, though, of unrelenting descent brought on by the GFC. Ares Capital (ARCC) – one of the best BDCs then as now from a performance standpoint – saw its stock price drop from just above $20 a share to just under $3.50 – a (82.5%) drop. To be forewarned is to be forearmed.

Happy Valentine’s Day.