Beware of bargains in private credit

Some investors may be tempted to jump into these publicly traded private-lending vehicles, which have been beset by concerns about the credit risks of borrowers like software companies. Many of these vehicles are currently available at deep discounts to their asset values, sometimes with high dividend yields. Be greedy when others are fearful, they say.

But buying shares of a BDC isn’t like buying a loan or a bond and just collecting the payments. And buying them cheaply doesn’t necessarily mean you will get more for your money. In fact, looking at those trading for a premium to their underlying net asset value could even make more sense right now.

For starters, many funds hold more than just loans. Their assets also often include equity stakes, sometimes even in other lending funds. These equity investments can be among the toughest for investors to assess.

On top of that, BDCs often earn various kinds of fee income through their lending. These can be collected when borrowers prepay their loans early by refinancing, or when a new loan is arranged. Fees can rise and fall with how active the lending market is. That is a separate risk from mere credit risk.

For example, Sixth Street Specialty Lending recently cited its outlook for a period of lower fees when discussing its decision to lower its quarterly base dividend. “Activity-based fee income can take several quarters to normalize following a market dislocation,” Sixth Street Specialty Lending Chief Executive Bo Stanley told analysts.

Other features of the kinds of loans that BDCs make also play into the ups-and-downs of their income. Some loan payments can be deferred, or what is known as a payment-in-kind. The idea is that allowing a borrower to preserve cash can help it through a rough patch.

But IOUs don’t bring in additional cash to the fund. So they can stress the ability of a BDC to keep paying its dividend, even if all its loans are technically current.

Returns on private-credit funds can be higher than what is available on traditional loans or other forms of corporate credit. But that higher return can also reflect the risks that differ from other debts. Researchers from Ohio State University argued in a recent study that private-debt funds’ returns should be measured with “an approach that adjusts for both equity and debt related risks.”

Marc Rowan, Apollo Global Management’s chief executive, has said that a more equity-like debt profile is what many investors were seeking out, particularly with BDCs. “This is not, people who have taken their Treasury portfolio or their investment-grade portfolio and gone into levered lending,” he told analysts on Apollo’s first-quarter call. “This is, people who have sold their equities to go into levered lending.”

Thinking of a BDC more like a stock may also suggest a seemingly odd path forward: Focusing on funds trading at a premium to their net asset value.

For a healthy fund to take advantage of the current anxious market by making higher-price loans, it may first need to raise more equity. That is much easier for a fund not already trading at a big discount.

Sixth Street Specialty Lending is one BDC trading at a premium to its net asset value, currently around 10%. The stock did fall after the firm cut its dividend, narrowing that premium.

But a dividend that is forgone for now isn’t necessarily gone forever. The Sixth Street BDC tracks so-called embedded fees it could earn from future activity. Some of funds’ activity fees also can act to protect them from loans being repaid early to be refinanced at tighter spreads. The ability to issue shares and lend at higher rates in the meantime also could boost future fee income.

To maintain a premium, though, investors will also have to continue believing a fund’s loans are worth what it says they are.

So even with all of the other things going on at BDCs, there is nothing enigmatic about their core mission: making good loans.

Write to Telis Demos at Telis.Demos@wsj.com