FSK - BDC Weekly Review: Private Credit Market Is Consolidating

2023-11-26 02:17:35 ET

Summary

• We take a look at the action in business development companies through the third week of November and highlight some of the key themes we are watching.
• BDCs had a good week with a total return of over 1%, but lagged behind other income sectors due to expectations of rate cuts.
• The private credit sector is consolidating, with larger firms like Ares Management and Blackstone dominating the market.
• FSK had a decent quarter however the steady pace of realized losses remains a concern.

Welcome to another installment of our BDC Market Weekly Review, where we discuss market activity in the Business Development Company ("BDC") sector from both the bottom-up - highlighting individual news and events - as well as the top-down - providing an overview of the broader market.

We also try to add some historical context as well as relevant themes that look to be driving the market or that investors ought to be mindful of. This update covers the period through the third week of November.

Market Action

BDCs had a good week with a total return of over 1%. Unusually, BDCs lagged most of the other higher-beta income sectors. This is likely due to the growing consensus view that the Fed is not only done but could be cutting the policy rate aggressively next year in response to continued disinflation and a slowing economy. Month-to-date the sector has enjoyed a sharp rally of around 7%.

Sector valuation has bounced nicely off the recent low. The experience from 2021, when valuations were even higher than today, shows that BDCs don't need high short-term rates to boast high valuations - they just need positive risk sentiment. This means the state of the economy in 2024 is likely more important for valuations than where short-term rates end up.

Market Themes

Most BDC investors already know that the sector is dominated by a small number of very large firms and a large number of pretty small firms. The chart below of top 30 BDC net assets clearly shows that, outside of the top dozen or so firms, the rest of the sector is made up of relative minnows.

What seems to be happening is that the broader $1.6 trillion private credit sector is consolidating further from current levels. A recent report described how top firms, including Ares Management and Blackstone, are deploying half of the total capital. Specifically, close to 60% of the total capital invested by private lenders comes from firms that lend more than $10bn each year.

This consolidation is likely not just because of brand recognition or large and established business networks of the larger lenders but because the deals themselves are growing larger and it is only the larger lenders that can digest these.

The lending pullback by banks as a result of loan losses in 2022 as well as the mini-crisis this year further solidified the position of the larger lenders who can take down a large bank portfolio fairly easily. For instance Ares bought a $3.5bn specialty finance portfolio from PacWest just this year.

Because of their size and level of activity, these larger lenders are also finding it easier to raise money for new funds. Blackstone recently raised $8bn for a new direct lending fund while Oaktree is looking to raise $18bn in what could be the largest private credit fund.

All of this means that, while private credit is attracting new players, it is becoming increasingly difficult for these new lenders to break through. Smaller funds lack the networks and the scale of the larger players and are not able to generate sufficient fees to pay the many credit analysts, structurers and workout specialists.

This existing scale advantage means we shouldn't expect the relatively small BDC sector to add many new entrants. The merger activity we have seen in the last couple of years in the BDC sector is another factor which will keep a lid on the number of BDCs.

This suggests that the modestly priced larger BDCs such as OBDC, ARCC, OCSL and others may be attractive holds over the longer-term as they could continue to benefit from their scale, wider lending opportunity set and larger potential deal sizes relative to the smaller players.

Market Commentary

FS KKR Advisor ( FSK ) put up good Q3 results. The NAV rose a bit less than 1% - primarily due to unrealized appreciation, a consistent BDC trend during the quarter. What wasn’t ideal is that there were net realized losses for the fourth quarter in a row.

Cumulative net realized losses for the last year are 6% - fairly high in the sector. The stock is trading at a 20% discount to the sector average valuation which is very reasonable.

Total NAV performance over the last 1-3 years is around the sector average level. The company underperformed during the COVID period so the concern is that a new shock could lead to another bout of underperformance.

Stance And Takeaways

There are three key factors that are top-of-mind for BDC investors at the moment. These are the likely state of the economy next year, the likely change to the Fed policy rate and BDC valuations. Further deterioration in leading indicators alongside relatively expensive valuations at the moment will provide an opportunity to adopt a more defensive allocation within the sector or to even pare it back to wait for a better entry point in the future.

For further details see: