Entry 15: Letter from the Leverage Belt: Private Credit’s Quiet Revolution

It is one of the peculiarities of modern finance that some of its most consequential developments unfold not in the glare of public markets, but in the half-light of structures few have heard of and fewer understand.

One such structure — the Business Development Company, or BDC — has quietly become a cornerstone of American lending. And like many things that grow too quickly, it now finds itself under the watchful eye of regulators, economists, and the occasional journalist. The BDC was born in the 1980s, a Reagan-era invention meant to encourage venture capital. But like many financial instruments, it has evolved far beyond its original purpose. Today, BDCs are the beating heart of the private credit boom — a market that has ballooned to over $1.7 trillion in direct lending, with some estimates reported by Bloomberg placing the broader private credit universe north of $40 trillion when asset-backed financing and investment-grade deals are included.

At its core, private credit is simple: a fund lends money directly to a company, bypassing the banks and the bond market. The appeal is obvious. For the borrower, it means flexibility and speed. For the lender — often a fund manager — it means higher returns, especially in a world of rising interest rates. Unlike bonds, which pay a fixed rate, loans typically float with the market. When the Federal Reserve hikes rates, loan investors smile.

BDCs have become the preferred vehicle for this kind of lending. They now manage half a trillion dollars in assets, with giants like Blackstone’s BCRED fund controlling over $70 billion. But here’s the twist: much of this money is borrowed. A typical BDC might take $100 from an investor, borrow another $100, and lend out $200 to mid-sized American firms — the sort too small to issue bonds but too large to rely on overdrafts. This leverage — the act of borrowing to lend — is what has regulators twitching. The Bank for International Settlements notes that BDCs are now responsible for a quarter of all direct lending in the US. And while their debt-to-equity ratios are capped by law at 2:1, the interconnectedness of these entities with banks and other lenders means that stress in one corner could ripple across the system.

It is, in some ways, reminiscent of the subprime mortgage market before 2008. Then, too, we saw a proliferation of opaque structures, high leverage, and a belief that risk could be managed with clever modelling. Today’s BDCs are not selling mortgages to unemployed homeowners, but they are lending to companies with chunky interest rates — often SOFR +600 basis points — because those companies are, by definition, risky.

And yet, the default rates have been astonishingly low. Around the Covid-19 period, they peaked at 2.5 per cent and have since averaged less than 1 per cent a year. But this figure may flatter the truth. When one includes “selective defaults” — payment-in-kind interest, maturity extensions, and other accounting gymnastics — the rate jumps to 6 per cent.

There is also the curious case of PIKs — Payment-In-Kind loans — which accrue interest without paying it in cash. These instruments allow BDCs to book income they haven’t received, and thanks to favourable tax treatment, distribute that phantom income to shareholders. It’s a bit like counting chickens before they’ve hatched, and then serving them for dinner.

Some BDCs, like Blue Owl Technology Finance Corp, have more than 15 per cent of their income derived from PIKs. Their managers insist this is perfectly safe — and perhaps it is. But when half the industry’s PIKs are considered “bad” by analysts, one begins to wonder whether the line between prudence and optimism has been crossed.

Still, the real risk may not be in losing too much, but in winning too much. The flood of money into private credit has led to spread compression — that is, lower returns for new loans. As interest rates fall and competition rises, BDCs may find themselves sitting on cash, unable to lend at attractive rates. And because their fees are often tied to investment income rather than total returns, managers have every incentive to chase yield, even if it means taking on more risk.

In the end, BDCs are not banks. They are non-bank lenders operating in a space once dominated by banks, now financed by banks, and regulated — or not — by a patchwork of rules. They are, in the words of one analyst, “bank-like non-banks” that may be safer than banks or may not be. The Federal Reserve remains unsure.

What is certain is that BDCs have become essential to American small and mid-sized businesses. They are the lenders of last resort, first resort, and every resort in between. And if pension funds, insurers, and retail investors continue to pour money into private credit, the BDC spigot will continue to gush.

Whether this ends in a gentle slowdown or a sharp correction remains to be seen. But as with all things in finance, it is worth remembering that what grows quickly can wilt just as fast. And in the quiet corridors of the leverage belt, the seeds of the next crisis may already be sown.

Source material and references

Private Credit Market Size and Structure
Used to support the $1.7 trillion figure and the broader context of private credit growth.
Bloomberg – A Changing Landscape for Private Credit

Global Drivers and BDC Cost of Capital
Used to support comparisons with banking regulation and systemic risk.
Bank for International Settlements – The Global Drivers of Private Credit

Performance of Private Credit vs Other Asset Classes
Used to support claims about investor returns and resilience.
Financial Times – Private Markets Reimagined

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