A brutal selloff of public business development companies has left investors struggling with a stark question: Are steep discounts signaling that a wave of defaults is coming or has fear run ahead of fundamentals?

Some public BDCs are trading have with discounts as high as 50 percent to net asset value. There is wide variance, often tied to perceptions of underlying credit quality.

Sid Malhotra, CIO and co-founder at Kactus Capital, a New York-based single-family office, said he’s avoiding most public BDCs, focusing instead on a high-quality group with more modest discounts.

Ares, for example, the largest publicly traded BDC, traded at a 5 percent discount to NAV with an indicated yield of 10.2 percent on April 16. As of Friday it was trading at a 0.2 percent discount to book value with a 9.9 percent yield, in line with normal markets, according to Bloomberg.

He would consider taking a modest position should the discount widen to 15 percent for a small handful of public BDCs.

But Michael Freedman, CIO at Bayberrie Holdings, thinks that default rates themselves are incorrectly calculated and that the risk of default for underlying loans is overblown.

As a result, he said his family office has been taking advantage of discounts and buying a wider selection of public BDCs consistently since President Trump’s tariff announcement in April deepened an already strained corner of the credit market.

One of his portfolios of seven public BDCs now trades at a weighted average price-to-net asset value of 0.76x and pays a yield of 12.4 percent, even after several dividend cuts, he said.

Because public BDC portfolios primarily contain first lien loans that historically tend to have recovery rates above 60 percent on defaults; a portfolio trading at 0.76x book value implies a 30 percent loan default rate.

“BDCs are leveraged about one time to equity, so if 30 percent of loans default that’s really 60 percent, but lenders only ‘lose’ 40 percent. Forty percent of 60 percent represents a 24 percent loss,” he said. That would imply a potential default rate significantly higher than during the financial crisis or the pandemic, he added

Determining if the discounts have bottomed out or if they are still likely to drop further is the difficult part, and getting it right is akin to “catching a falling knife,” said Malhotra.

“We stay with the firms that are proven credit investors in different environments. Junk usually gets worse,” he said. “We prefer to leg into such investments to maintain flexibility and dry powder, since no one rings the bell at the bottom."

But if the default predictions implied by the discount rates are correct, then the market has far bigger concerns than public BDCs, said Freedman.

If Freedman’s portfolio of seven BDCs, with around 200 loans each, had 30 percent defaults, it would mean 420 different private equity-backed companies defaulting, he said.

“It is impossible to square the panic in direct lending with the equanimity in PE that is the bottom 55 percent of these capital stacks. One must be wrong.”

Either public BDCs are either a “screaming bargain” or stress has yet to emerge in private equity markets, he added.