Jonathan Bock made arcane lending vehicles sexy by naming, grading, and sometimes shaming industry players. But Bock became much more reserved — read silent — once hired as the chief financial officer of Barings BDC in July 2018.
The former star Wells Fargo Securities analyst has piped up once again, warning investors about four primary mistakes they’re making in private credit.
Chief among them, Bock wrote in a Barings blog post Thursday, is that investors assume middle-market loans will have fewer losses than their broadly syndicated counterparts based on what happened in the last cycle. Plenty of things are different today, he argued, including more leverage and looser protections — or covenants — for lenders to mid-market companies.
“It’s hard to ignore the drama” in private credit headlines these days, he wrote.
“On one extreme, there is a view that this asset class is akin to James Milton’s Shangri-La — offering utopian risk-adjusted returns from lending to middle-market borrowers who can smartly handle their debt. Such a view, unsurprisingly, leads to new capital being raised by managers happy to grow assets under management,” Bock wrote. “The other extreme, of course, is dystopia — the view that substantial industry competition will lead to an eventual loosening of terms and a flood of future losses.”
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Regarding mistake number one — investors’ belief that middle market loans will continue to provide better risk-adjusted returns than syndicated loans — Bock highlighted the modest leverage that middle-market companies had employed during the last cycle. They quickly refinanced and repaid their debt after the financial crisis. In comparison, larger companies took about two more years to get to the same level of financial health. Now that’s changed, with companies great and small equally indebted. Covenants, too, have loosened, which will affect defaults and how much cash investors ultimately recover after a company stops paying their debts.
Investors are also overvaluing large managers’ scale, thinking that size guarantees access to the largest private deals. In fact, Bock argued, organizational heft in private credit, just like in other asset classes, can lead to subscale returns.
In addition, investors who favor larger managers reward their marketing capabilities. More than 37 managers have the ability to invest $100 million or more at one time, according to Refinitiv data that Bock cited.
The Barings private credit executive points out another risk with investing in the largest managers.
“In the world of institutional investing, there is a saying along the lines of: thou shalt never invest at a liquid price, at terms comparable to the liquid structure, but do so in an illiquid wrapper,” wrote Bock. “Translating that to common English: lenders must price and structure loans to compensate for illiquidity — or the risk of not being able to sell a security. This sounds easy in theory, but in reality — as many managers move away from principal investor (i.e. investing on their own behalf) and into the world of credit asset managers (i.e. investing on behalf of others and collecting management fees) — the illiquid spread premium begins to vanish.”
The third mistake is buying managers’ boasts about their deep relationships with sponsors, access to unique deals, ultra-high quality research, and due diligence teams, per Barings. Investors who understand the math will know “whether or not [managers] are forced to take unnecessary risk to achieve promised returns.”
Lastly, being senior in the capital structure — meaning investors get paid first in the event a bankruptcy — doesn’t always pan out. Structures have changed over the years and some managers have stretched definitions.
“To mitigate the risk of definitional creep, investors can start with the first line of defense: alignment. It is harder for managers to aggressively redefine senior risk when the loan in question sits on the manager’s balance sheet,” wrote Bock.