Private Credit Stocks Are Rebounding, but Shared Loans Bring Growing Risk

The overlapping portion of Business Development Company funds is rising. (Michael Nagle/Bloomberg)

Key Points

• Raymond James analyst Robert Dodd notes a substantial increase in overlap between BDC nonaccrual exposures, meaning more funds share problem assets.
• Morgan Stanley Direct Lending Fund has the highest total overlap, sharing 85% of its borrowers with some other fund.
• The two lenders with the greatest overlap with each other are Blackstone and Morgan Stanley.

Private credit stocks have climbed in recent months from the ditch where investors dumped them earlier this year.

That doesn’t mean investors can stop worrying.

Problem loans are what have concerned them, and one way to monitor the impact of those loans on the industry is to look at how many are shared across different funds.

Portfolio overlap is what Raymond James analyst Robert Dodd calls the loans in a fund portfolio that also appear in other credit funds. Dodd covers the credit funds that operate as Business Development Companies.

The overlapping portion of those BDC funds has risen from about 10% of the average portfolio in 2010, to over 55% today, according to Dodd’s Friday note.

One reason for that increase is that BDCs are lending to bigger borrowers. When a private-equity firm buys out a large business, they leverage the business with a large loan. Individual credit funds will take just a piece of that loan, and so those pieces show up in more than one private credit portfolio.

By taking small pieces of big loans, the BDCs can better diversify their holdings. That’s a good thing. And at a time when some question how private funds value their non-trading assets, shared loans let a diligent investor compare how different credit firms value the same loan.

But a worrier might wonder if defaults by the shared borrowers could wallop many lenders at once—causing their loan problems to correlate. Investors hate correlation.

Sure enough, as loan overlap has risen, there has been an even sharper rise in the overlap of problem loans that aren’t making their payments, that is, in non-accruing loans.

“There has been a substantial increase in overlap between BDC nonaccrual exposures,” Dodd notes. That means a greater numbers of individual BDCs are exposed to the same problem assets.

Among the few dozen BDCs he studies, the $3.6 billion Morgan Stanley Direct Lending Fund has the highest total overlap, sharing 85% of its borrowers with some other fund. At Blue Owl Capital funds, overlap is about 70%, while at Blackstone and Ares Management funds, their respective overlap levels are around 60%.

The two lenders with the greatest overlap with each other are Blackstone and Morgan Stanley, where 36% of their portfolios are loans to the same borrowers.

Shares of the Morgan Stanley BDC are up 27% in the last two months, while those of the industry-leading Ares Capital Corp . are up 12%. The private credit fund managers Ares Management and Blue Owl are up 34% and 41%, respectively. That all compares with a two month gain by the S&P 500 of under 4%.

Dodd wonders how much difference there is among BDCs these days.

“Does buying multiple BDCs give you the same diversification it did in the past?” he asks.

Write to Bill Alpert at william.alpert@barrons.com

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