I typically stay away from truly controversial stocks, but the current hysteria around all things private credit and software is going a bit far, with some journalists and Substack writers openly cheerleading for a meltdown. As someone who worked in the middle of the GFC, the comparisons don't make sense to me.
A quick background, direct lending became popular following the GFC when banks pulled back on making middle market commercial and industrial loans due to increased capital requirements (plus a general reduction in risk taking). Unlike banks, private credit funds don't utilize deposits as a funding source, instead these funds generally have locked up capital that can withstand the 3-5 year maturity lifecycle of these illiquid loans. The current private credit market is primarily composed of below investment grade borrowers, most of which are PE sponsored. Fast forward, financial innovation was taken a bit too far. On the hunt to raise additional capital, alternatives managers turned to the wealth channel where they sold interval funds offering periodic liquidity (usually capped at 5% per quarter) despite the underlying assets being relatively illiquid. The pitch is pretty simple, private credit offers equity like returns (especially when short term rates were elevated) with minimal volatility since the underlying loans don't trade (a selling point to the borrower, they know their lender), capital poured in over the last 2-3 years.
This past fall, a couple scary headlines around fraud at First Brands (bank led, syndicated loan) and Tricolor (bank lead, but not syndicated), neither of which were private credit loans, sparked a wave of concerns around the broader leveraged lending industry. First signs of stress were felt in the publicly traded BDCs falling to significant discounts of their stated NAVs (industry average is currently ~75% of NAV), followed by redemption requests from investors in non-traded BDCs. With public BDCs trading at wide discounts, the natural trade for someone who still believes in private credit and is sitting in a non-traded BDC is to redeem at NAV and buy shares in a substantially similar publicly traded BDC (many managers have both publicly traded and non-traded BDCs which share allocations) at a discount. Although, I suspect most of the redemptions are simply scared investors wanting out entirely.
Blue Owl Technology Finance (OTF)
Blue Owl (OWL) is at the center of the storm, it's a fast growing alternatives manager (not sure if "fast growing" carries the same risks as in banking, but it's probably close!) focused on private credit with an overweight to technology and software companies, including some dedicated technology strategies. Blue Owl has the 2nd and 3rd largest publicly traded BDCs by NAV, Blue Owl Technology Finance Corp (OTF) and Blue Owl Capital Corporation (OBDC), which trade at approximately 67% and 77% of NAV respectively (may have changed since writing). Part of Blue Owl's strategy has been to raise capital in non-traded BDCs and bring those public after achieving sufficient scale (OTF came public in June 2025 this way), but that strategy came to halt when Blue Owl tried to bring Blue Owl Capital Corp II (OBDC II) public by merging it into OBDC at an NAV-to-NAV basis when OBDC was trading at a discount. They naturally received backlash and reversed course, but the damage was done and they received significant redemption requests. In February they announced they'd be liquidating OBDC II and returning capital to investors, despite the bad press, this is the right move. Investors will likely get near or above NAV (including interest) as the loans are sold or are paid off (again, loans have short average lives).
That brings us back to OTF. Advancements in artificial intelligence have given a haircut to arguably previously extreme valuations in the software sector. Count me as a bit of an AI skeptic, but in my day job we've been trying to utilize AI tools to extract information from a PDF and ingest it into a downstream system with limited success. This is a task we've looked to offshore or generally use entry level employees for and still haven't been able to make it work reliably with current AI technology. I have a hard time believing that AI is going to render the entire software sector useless in under a few years (again, most private credit loans have relatively short average lives) where the equity will be wiped out and credit providers impacted. Additionally, any software that is embedded in a large organization's operations is extremely difficult to displace, its just not worth the risk to rip out, replace with a vibe coded alternative and explain that to your clients and regulators. No chance. I think most spreading these fears have never worked on a core platform transition, its very difficult.
OTF is a very large BDC, $14B of assets and is currently under levered with a debt-to-equity ratio of 0.75x (below the average of ~1x) giving them flexibility to continue lending, fill the hole of others that will be backing away and likely getting better terms in the current turmoil.
- Scale here can equal a higher quality portfolio. Smaller software companies are more at risk for AI disruption than those with significant embedded client relationships. OTFs size gets it both into the larger more stable credits and provides diversification.
- OTF recently upsized their share repurchase program to $300MM, they utilized about $65MM of the old repurchase plan in the second half of the year. Not super significant given the overall size, but does show some alignment with minority shareholders. Although I'd like to see more, with the stock trading at a significant discount, almost no investment can match the returns of share repurchases.
- Only about 50% of the shares are currently in the float, this is a former non-traded BDC and as unlocks happen, the shares might come under further pressure as private credit and software concerns continue to swirl.
- OTF has an equity position in SpaceX, about 2.5% of net assets, there are reports that SpaceX is planning to go public later this year, potentially providing an exit opportunity at a high valuation.
CLOs vs CDOs
I've seen a lot of comparisons calling private credit today similar to CDO's of 2007, including the former Bond King himself, Jeffrey Gunlach:
Total nonsense (and he knows it).
Again, nonsense, someone that is just looking for clicks.
A brief history, the underlying assets of collateralized debt obligations (CDOs) were BB and single-B tranches of non-agency subprime RMBS (or even worse, BB/B tranches of other CDOs) from the likes of Countrywide and Washington Mutual. Inside of those RMBS transactions were subprime mortgages that were then split into tranches, the CDOs bought up the junior most slices just above the equity. Despite the BB or B rating, these securities were effectively binary, if they defaulted there was little chance of recovery because the senior tranches in the RMBS would be paid first. Almost all of these mezzanine tranches completely were wiped out with zero recovery.
In a CLO or a private credit CLO, most of the loans are also rated BB or B by design, the PE firms leverage the balance sheet of the underlying borrower to the point they achieve this rating knowing that it fits the investment mandate of a CLO. The difference between a CLO and CDO however is in: 1) loans in a CLO are senior secured, meaning they're the top of the capital structure, not the bottom like in a CDO despite the same rating (there will be some recovery on the loan, let's say 30-70%), 2) there's actual diversification in a CLO, usually there a couple hundred loans in the underlying collateral pool, mixed across many industries (unlike a CDO which was just a leveraged bet on high-LTV housing). Not to mention there's no such thing as a synthetic private credit CLO, in 2006 you'd often see CDOs long credit default swaps on tranches of RMBS that were multiples of the cash value of the underlying, that's not happening today. It's not the same.
BDCs and private credit funds generally have low leverage, something like 1-1 debt-to-equity (even though the legal limit for BDCs was raised to 2-1, most are well below that), then sometimes the BDC or fund will issue a CLO, but again these will have relatively low leverage thanks to the Volker Rule which requires the issuer to retain risk (the issuer of a private credit CLO or a CRE CLO generally retains the junior tranches and equity). Banks don't really participate in the private credit CLO market, it's mostly insurance companies or others that don't have deposit funding buying the senior tranches. You can think private credit was poorly underwritten, etc., but there's limited contagion risk when compared to the GFC. There would have to be a great depression like event where many/most industries are annihilated to create losses to the senior tranches of CLOs (either broadly syndicated or private credit). To illustrate the math, the AAA tranche of a CLO (the portion held by banks and insurance companies) makes up about 60% of the capital structure, in order to take losses, using the current recovery rate of approximately 50%, 80% of the underlying loans would need to default. Unlikely given the diversification.
Carlyle Credit Income (CCIF)
For those that want even more juice to the turmoil in credit, look no further than Carlyle Credit Income (CCIF), this is the former Vertical Income Fund (VCIP) that Carlyle (CG) took over in 2023, changing the strategy from a boring mortgage fund to CLO equity.
CLO equity is an odd security, especially to be packaged into a publicly traded equity, it is the residual piece of a securitization whose value is highly levered to the value of the underlying bank loans. However, CLOs are not mark-to-market vehicles, they are actively managed pools that have medium-to-long term financing and the underlying bank loans have relatively short weighted average lives (2-3 years typically, stretching out a bit during tougher times) where the manager can reinvest those principal payments coming back to them at par into secondary market loans trading a discount, dubbed "building par" which accrues to the equity. A volatile market is actually good for the equity, the best returning vintages of CLO equity were during the GFC when loans were trading at significant discounts that eventually recovered.
Unlike private credit, CLO equity does have a secondary market with some liquidity (wouldn't say its a liquid market however) and CCIF has legit marks on their assets. CLO equity prices swing a lot with the value of underlying loans. 1/31 NAV is $4.79, it currently trades for 70% of NAV and represents an interesting opportunity. As loan values recover, the NAV will be highly geared and likely to move up substantially unlike BDCs where most of the skew is to the downside.
Mount Logan Capital (MLCI)
MLCI is a recent reverse merger that came public in U.S. markets last year, they're a private credit asset manager with a bunch of lowish quality management contracts they've rolled together over the last several years from failed management platforms. Following a tender offer, MLCI is trading at somewhere around 50% of book value with a decent amount of liquidity thanks to merging with CEF TURN providing it with a securities portfolio that could be liquidated in order to make more acquisitions. One of MLCI's mandates (through a convoluted JV structure) is the external manager of BCP Investment Corporation (BCIC), a small $520MM asset BDC that trades for sub-60% of NAV.
On BCIC's recent earnings call, management made it fairly clear they're mostly interested in growing the platform (potentially at the detriment of shareholders, it got a little chippy during the Q&A) and view the current market turmoil as a potential opportunity to roll up more failed BDCs.
Edward Joseph Goldthorpe BCP Investment Corp. – Chairman, CEO & President
Yes, it's a great question. So I don't see us pursuing organic growth. I mean if anything, given where our stock trades, it makes sense for us to continue to buy back stock. So the tender plus share buybacks, obviously, were a pretty nice tailwind for us or not per share.
In terms of like all this recent choppiness in the market and all the recent headlines, our M&A pipeline is probably bigger than it's ever been. And that includes both public entities and listed entities. So we expect to be able to grow our platform. We had to get Logan Portman done. And that sets us up to do continued M&A. So as you know, we've kind of rolled up a number of BDCs over the last couple of years, and it's a key part to our strategy to basically continue to do that, optimize the portfolios and continue to buy back stock.
If I had to guess, I'd say Great Elm Capital Corp (GECC) and their manager Great Elm Group (GEG) would make a good fit. GECC got caught up in the First Brands mess and experienced a big write-down as a result, however, it trades at a premium to BCIC today. MLCI (and BCP) could end up acquiring GEG and eventually rolling GECC into BCIC like they have with other BDCs, run it separately for a bit until the timing and valuation make sense for a merger.
Disclosure: These are just my own personal views. I own shares of OTF, MLCI and CCIF (CCIF in an account that sits outside of the portfolio I track on my blog)
Have you looked at Sallie Mae, $SLM?
ReplyDeleteNot in a long time, thanks, I'll add to my list.
DeleteI think the basic problem is that there has been a mad rush into private credit (like tulip bulbs in the 17th century, British railway bstocks in the 1840's, the dot.com bubble,...). This has resulted in a lot of money chasing fewer 'opportunities" for both credit and private equity. The private equity buyers' competition has resulted in higher prices paid coupled with increasing leverage for their buyouts. Private credit loan covenants have basically disappeared (later loans can be used for dividends for example instead of paying off earlier loans). The result is a lot of over priced and over leveraged assets even duringmabe necessary economic growth. The continuing drip of losses (some 11 % of PC loans are now PIK) plus any future recession will cause no end of losses, unless the Fed turns on the printing presses to save the economy, because a lot of the PE and PC managers' funding comes from the banks.. The other problem (per Grant's Interest Rate Observer) is that PE managers have taken over life insurance companies and raided (equity to asset ratios are often less than 3 %) their policyholder funds (like annuities) to fund LBO's. A credit crunch could wipe out a lot of annuities and life policies.
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