Private Credit

What is Private Credit (aka Private Debt)? top

Private credit, which is sometimes called private debt, involves loans made by private companies rather than commercial banks. Here, “private” refers to institutional and individual investors, who act as the lender.

Who Are the Borrowers?

The borrower is typically a company in need of cash to achieve specific goals, such as developing real estate, building infrastructure, or improving operations. Borrowers in the private credit market tend to be small to middle-market companies, ranging from $3 million-$100 million in EBITDA. This market is split between the traditional middle market companies (with upwards of $50 million in EBITDA) and the lower middle market (with under $50 million and averaging $15 million-$25 million EBITDA).

Private debt can include direct lending, mezzanine funds, distressed debt, and special situations. As banks are increasing loan requirements (which often favor large corporations), borrowers include small and medium-sized enterprises that don’t have ready access to bank financing and businesses that need funds quickly.

Unlike private equity funds, investors don’t use private debt funds to own shares in a company. As with most loans, borrowers pay lenders back with interest over time and according to specified terms.

Who are the Lenders?

(Source: S&P Global)

Business Development Companies (BDCs) are central players in the private credit market as direct lending is their core business. Asset managers are central to the private credit market through their lending platforms. It’s not unusual for asset managers to operate lending platforms that include multiple lending vehicles, BDCs, private debt funds, middle-market CLOs, and mutual funds, thus enabling them to gradually offer larger loans. Loans originated by a BDC in the lending platform may be distributed to private debt funds, or middle-market collateralized loan obligations (CLOs) that are managed by the same institution. With exemptive relief from the SEC, the asset manager may co-invest alongside the BDC and the private debt vehicle in the same deal, resulting in larger pieces of the deal for the same asset manager. Through its lending platform, an asset manager can allocate a loan across several of its managed vehicles, which are frequently enhanced by leverage.

With investor hunt for yield unlikely to diminish, the private debt market looks poised to add to its recent explosive growth. Financial analysts predict private credit assets under management will reach $2.6 trillion by 2026 (Source: Prequin, 2023).

The illustration below shows the differences between a syndicated loan and private credit.

What are Business Development Companies (BDCs) top

BDCs invest in small- and medium-sized companies, as well as distressed companies, to help them grow in the initial stages of their development. With distressed businesses, the BDC helps the companies regain financial footing. They raise capital through initial public offerings or by issuing corporate bonds and equities or forms of hybrid investment instruments to investors. The raised capital is then used to provide funding for companies. BDCs can use different financial instruments to provide capital, but in general, most issue loans or purchase stocks or convertible securities from the companies.

BDCs v. Venture Capital Funds

BDCs differ from Venture capital funds (VCs) in that VCs are primarily available to large institutions and wealthy individuals through private placements. In contrast, BDCs allow smaller, nonaccredited investors to invest in them, and by extension, in small growth companies. Additionally, Venture capital funds keep a limited number of investors and must meet specific asset-related tests to avoid being classified as regulated investment companies. On the other hand, BDC shares are typically traded on stock exchanges and are constantly available as investments for the public.

BDCs combine attributes of publicly traded companies and closed-end investment vehicles, giving investors exposure to private equity- or venture capital-like investments. They can be exchange-traded, public non-exchange traded, or sold through private placement. By investing in a BDC, individual investors can access investment strategies, such as direct lending, that have historically only been accessible to institutional investors or high-net-worth individuals.

How did they originate?

BDCs were established by Congress in 1980 as part of the Small Business Development Act, which primarily sought to encourage the flow of capital to small and middle-market companies within the U.S. at a time when bank balance sheets were strained.

Over the ensuing four decades, banks have become less economically incented to originate and hold private, non-investment grade loans to small and middle market companies due to regulatory changes implemented following the Financial Crisis of 2008. At the same time, BDCs have grown with the non-bank direct lending industry, evolving into a straightforward and generally tax-efficient vehicle that facilitates individual investor capital investment in small and middle-market companies.

The investment process of a BDC is either internally managed by its own employees or, more commonly, externally managed by an investment advisor pursuant to an investment advisory agreement.

As of June 2021, there were more than 85 BDCs with approximately $140bn in combined assets under management, approximately half of which were exchange-traded. The vast majority of BDCs were created in the last 15 years as the direct lending market scaled and matured.

Private BDCs top

A Private BDC is hybrid between a Private Fund and a Traditional BDC. Its features include:

Typically sponsored by large private equity firms with existing investor relationships

Shares are sold through a private placement offering
Shares are generally only sold to accredited investors
Capital is generally raised by a capital call model, similar to a private fund structure
Investors enter into a subscription agreement with the BDC

May contemplate a liquidity event

Exchange listing or some other liquidity mechanism including a spin-off or merger

BDC reporting, governance, and investment limitations

Reporting required by the Exchange Act of 1934 (the 1934 Act)
Compliance with the Investment Company Act of 1940

General Advantages

Capital Commitment Structure: Allows committed funds to be drawn as investment opportunities arise
Optionality: “Liquidity Events” may be determined in the future; fee structures may be different before and after a liquidity event
Potentially Shorter Process: Form 10 may be effective in ~60 days and no listing process
Fewer Filings: Private placement eliminates “blue sky” registration process of non-traded
BDCs sold in a continuous offering
Structuring Advantages: BDC/RIC structure mitigates the need for an offshore feeder fund structure for foreign/tax-exempt
investors
No Withholding on Certain RIC Dividends: Non-US investors not subject to US tax on interest-related, short-term capital gain, or long-term capital gain dividends

Tax Disadvantages

Diversification and Income Limitations: Must satisfy
RIC asset-diversification and income tests.Diversification tests beginning as of the end of the first quarter
Pass-Through of Miscellaneous Itemized
Deductions: Non-publicly offered RICS must gross up
dividends to US non-corporate investors by expenses
that would be treated as miscellaneous itemized
deductions if incurred directly by the investors. It includes management fees and misc itemized deductions that are not currently deductible (and subject to limitations beginning in 2026)

Common Types of BDCs top

BDCs invest in several different types of non-public securities, which often include tiered investment structures.

Senior secured debt is a top-priority debt repayment secured by collateral. If a company is liquidated, senior debt is settled first, and if it's a secured debt, collateral assets can be sold to cover the debt.

Subordinated or unsecured debt such as junior debt is collected after higher-priority debt has been paid. Unsecured debt is not backed by any collateral, which presents a much higher level of risk to investors.

Preferred stock is an upper tier of corporate equity shares that grant stockholders higher claims to dividends and asset distribution.

Common stock is the bottom tier of corporate equity shares. Common stockholders' earnings on dividends vary and are subordinate to preferred stockholders. In the event of liquidation, common stockholders are last in line for asset distribution.

Similarities with other Investments top

How are publicly traded BDCs similar to other SEC-regulated investment funds?

Below are some ways BDCs are similar to other investment funds such as mutual funds, closed-end funds, and exchange-traded funds (ETFs):

BDCs pool money from many investors and invest that money.
All types of investors, including retail investors, can own shares.
Investors own shares representing a pro rata or proportional part of the BDC.
BDCs’ are regulated by the SEC.
BDCs’ investment managers may be investment advisers that are registered with the SEC.
Publicly traded BDCs are also similar to other closed-end funds and ETFs: their shares are typically bought and sold on national securities exchanges at market prices.

Qualifying as a BDC top

To qualify as a BDC, a company must be registered in compliance with Section 54 of the Investment Company Act of 1940. In addition, it must be a domestic company whose class of securities is registered with the Securities and Exchange Commission (SEC).

The BDC must invest at least 70% of its assets in private or public U.S. firms with market values of less than US$250 million. The BDC must provide managerial assistance to the companies in its portfolio.

Business development companies avoid corporate income taxes by distributing at least 90% of their income to shareholders.

How do BDCs Make Money? top

One of the most common ways a BDC makes money is to purchase equity from the companies they provide funding for and sell it when it appreciates. If a BDC buys convertible bonds from a company it has invested in, it can receive yields from the bonds and later convert them to equity. Once converted, the equity can be held for appreciation or sold for capital gains. Lending is another way BDCs make money. Similar to a consumer borrowing from a bank, a BDC charges interest on the loans it makes.

Risks & Benefits top

(source: www.investor.gov)

Investment Risks. BDCs invest in small and medium-sized companies that are developing and/or financially distressed. Many are private companies that don’t make public disclosures, and the shares of the companies do not regularly trade on a national securities exchange.

What this means for investors: BDCs’ equity investments have potential for growth and their debt investments may earn higher interest rates than those of other debt investments, so BDCs may seek to achieve a higher return than other types of funds. But such equity or debt investments could also increase BDCs’ risks. There are risks in owning shares or loaning money to the small- and medium-sized companies that are different from, and in some ways more significant than, investments in larger public companies. These smaller companies may be more likely to go out of business or default on their debts. Also, it can be difficult to find information about the companies BDCs invest in and to know for sure what they are worth.

Different Investing Opportunities. At least 70% of a BDC’s total assets must be invested in certain types of investments, including certain privately issued securities, distressed debt, and government securities.
What this means for investors: BDCs can offer a different investing opportunity for retail investors than is offered by typical mutual funds, ETFs, or other closed-end funds. Investing in a wider range of assets can be a good tool for portfolio diversification and may mean that a BDC follows movements of the stock market less closely. But these investments can expose you to certain risks, as described in this Investor Bulletin.

Exposure to Leverage or Debt. BDCs can and often do use more leverage or debt than other types of funds to purchase their investments.
What this means for investors: BDCs’ use of leverage can increase your return but can also increase your losses. It can also increase risk and can make the price of BDC shares more volatile. In addition, it can be more expensive for BDCs to borrow to invest if interest rates go up. Higher interest rates can also reduce BDCs’ profits.

Paying a Premium or Discount. The market price for BDC shares may be greater or less than the shares’ net asset value (NAV). Shares that sell at a price higher than the NAV are said to be sold at a premium, and shares that sell at a price lower than the NAV are said to be sold at a discount. BDC shares may sometimes trade at a discount, but may sometimes sell at a premium.
What this means for investors: Trading at market price means you may pay more or less for BDC shares than the current value of the fund’s underlying investments. This pricing creates an additional layer of risk and opportunity when owning BDC shares. If you purchase shares at a premium, you are paying more than the current value of the underlying investments. If you purchase shares at a discount, you are paying less than the current value of the underlying investments, but you may not be able to sell the shares other than at a discount.

Potentially large distributions. BDCs’ distributions can include income generated by the fund – interest income, dividends, and/or capital gains – but can also include a return of capital. Because of their tax structure, most BDCs (that have elected a certain tax status) must distribute 90% of their taxable income to their investors each year.
What this means for investors: BDCs may pay large distributions. If the distributions include a return of capital, BDCs may not be as tax-efficient as other investments. In addition, a return of capital means you are getting back some of your principal, which is the money you originally invested. A distribution that includes a return of capital reduces the BDC’s asset base (the money the BDC has available to invest) and may make it harder for the BDC to make money in the future. It also means that the value of your remaining investment in the BDC may decline. When a distribution includes a return of capital, the BDC will send you a written notice.

Higher Fees. BDCs often have higher fees than other investment funds, like mutual funds or ETFs. Typically BDCs that are managed by an investment adviser have an advisory fee, which is generally equal to 1.5% - 2% of the fund’s gross assets annually, plus certain incentive fees generally up to 20% of any profits earned. Because management fees are typically calculated on gross assets, which would include leverage, the actual management fee charged to investors may be higher depending on the amount borrowed by a particular BDC. Also, BDCs’ operating expenses may be higher than those of other types of funds. In addition, if an investor buys BDC shares in the initial offering, the investor will pay a sales charge or commission that will be a certain percent of the purchase price. If an investor purchases BDC shares on a securities market, the only transaction fees the investor pays are typical brokerage commissions.
What this means for investors: These fees reduce the value of your investment. If you buy BDC shares in the initial offering, you will likely pay higher fees than if you were to buy the shares of the same fund later on a securities exchange. In addition, typically the price of BDC shares immediately decreases after an initial offering, and the shares sell at a discount. If you buy or sell BDC shares on a securities exchange, you will pay a typical brokerage commission, but not any sales loads or purchase or redemption fees.

Regardless of whether shares are purchased in an initial offering or on a securities exchange, investors will pay for the BDC’s operating expenses. These expenses – management fees, distribution fees, and shareholder services fees – are paid indirectly by shareholders out of the BDC’s assets. For a list and explanation of fees associated with a BDC investment, investors should review the fee table, which is available in the fund’s prospectus, or other relevant fund documents.

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