"This is something we’ve been talking to clients about frequently in recent months,” said Thomas Friedmann, co-head of Dechert’s permanent capital practice and an advisor to BDCs on their own capital markets activities. “People aren’t bringing new deals until they have to.”

BDCs and commercial lenders have only about $1.3bn in debt coming due this year, according to S&P. But that jumps to $5.1bn next year, $7.9bn in 2025, then $13.5 in 2026 and $7.3bn in 2027.

Source: S&P

Catch ‘22

The worse-case outcome is a kind of negative arbitrage: BDCs could end up with an overall cost of capital that is higher than the interest income they receive from the loans they originate.

Until recently, that was pretty much unthinkable. But then came 2022, and everything changed.

Recent BDC debt issuance has been slow, but last month Owl Rock Core Income Corp (ORCIC) issued a $500m five-year unsecured bond at a 7.95% coupon, with a slight OID that pushed the new issue yield to just over 8%.

For reference, that same Owl Rock vehicle issued unsecured debt in 2021 at a 3.125% coupon. Around the same time, some of its peers issued similar bonds with coupons under 3%.

The differential between then and now shows how much the market shifted last year, when Russia invaded Ukraine and fears about the global economy pushed central banks to hike rates. Just like their borrowers, BDCs are now under intense pressure to adapt to this new paradigm — but it’s a thorny problem, and all the solutions come with significant caveats.

“The problem with issuing debt in the unsecured market now is you are stuck at current interest rates for 3-5 years,” said Friedmann. “That’s the discussion: what is the best way to approach this?"

Slow squeeze

Borrowing at today’s rates wouldn’t automatically break the BDC model, and negative arbitrage isn’t necessarily an immediate threat. But the higher cost of capital could definitely start to eat into investment returns.

The weighted average yield in ORCIC’s lending portfolio was 11.4% as of 31 March, according to SEC filings. Sources estimated that BDCs can currently book 11%-13% yields on newly issued first lien loans.

That’s a lot higher than the 3% unsecured funding costs many BDCs had back in 2021, but not much above the 8% all-in yield on ORCIC’s recent bond issue.

That bond issue wasn’t technically a refinancing: ORCIC was raising debt in concurrence with an equity raise, to keep its debt-to-equity ratio in check, noted Jonathan Lamm, CFO and COO of Blue Owl’s BDCs. The ORCIC vehicle aims to maintain a 1:1 debt-to-equity ratio.

Nevertheless, the deal provides a barometer of current funding costs for BDCs, and helps explain why very few of them have refinanced this year.

Essentially, no one wants to take the risk of refinancing at peak rates only for base rates to fall shortly afterwards.

“If you’re signing up for something at 5 years and if your floating rate loans come down, you have negative arbitrage,” said a banker who advises BDCs.

The only reason to hit the market now would be if you had absolutely no choice, sources said.

“If you need to issue, you’re going to issue, that’s the short answer,” said Matt Stewart, chief operating officer at Oaktree Specialty Lending BDC. “We’re taking a patient approach to it. We haven’t issued this year and we’re watching the market.”

Why not float?

One way to mitigate the risk of negative arbitrage would be for BDCs to issue floating-rate debt, so their own interest costs would come down in tandem with the coupons of their borrowers. Indeed, most BDCs already use floating rate debt for their short-term borrowing, such as revolving credit facilities.

However, using too much floating rate debt can put BDCs at risk of being downgraded: ratings agencies generally prefer a certain amount of unsecured debt, which is typically structured as fixed-rate bonds that are sold to investment grade credit investors.

Some BDCs also hedge their interest rate exposure, but that too can eat into returns. “The cost of hedging is pretty high,” said Kipp DeVeer, CEO of Ares Capital Corporation, during the vehicle’s first quarter earnings call in April.

Keep it short

Another way to address the tricky refi dynamic could be to issue debt at a shorter tenor. Blackstone Private Credit Fund did that last September, when it issued $800m of 7.05% unsecured notes with a three year tenor rather than the usual five years.

The problem with this solution is that shorter-dated debt forces you to come back to the market sooner to refinance again.

That means paying fees to investment bankers and lawyers, as well as offering investors some kind of new-issue concession. Moreover, three year debt issued today would mature in 2026, the peak of the current maturity wall, so issuers would have to fight harder for investors’ attention.

The bigger picture

One potential outcome of this challenging situation is that investors find themselves forced to become more selective in terms of which BDCs they choose to back. That applies both to the fund managers that buy their unsecured bonds, and the banks that provide them with other debt facilities, such as revolvers.

“Banks I think have started to really rationalize and think about platform exposures and picking and choosing,” said Meghan Neenan, a managing director at Fitch Ratings. “Unsecured investors are going to be doing the same.”

This has potential implications for BDCs’ growth plans, and by extension for the growth of private credit in general, sources said.

“Who gets left out in the cold, or who isn't able to keep pace […] is a big question,” said Neenan.

Many BDC managers are putting a brave face on this uncertain outlook, confident that their funding sources are sufficiently diversified.

"There is a lot of financing available to the private credit universe, across both secured financings from banks and CLOs, and unsecured financing, which has been an expanding buyer base,” said Stewart at Oaktree.

It also has to be said that many other buyers of floating rate loans — such as CLOs — currently have their own challenges. So perhaps this is just another example of how elevated rates are having an impact across the corporate credit market more broadly.

But the threat of higher funding costs to BDCs is not insubstantial. Direct lenders’ competitors in the BSL space are already able to undercut them on pricing — how big can that pricing differential get before it outweighs the other supposed benefits of private credit, like bespoke structures and greater certainty of execution?

For now, the lenders we spoke to are confident that private credit’s other selling points will be enough to mitigate higher pricing. Here’s Lamm at Blue Owl:

"Will there be an increase in costs to the corporate borrower going to our market? Yes. But even though costs are going up in general, we are seeing the corporate borrower and the sponsor-owned borrower want to come to our market because of certainty of terms and financing."