Interest Rate Cut Cycle Hits; U.S. Publicly Listed Private Credit Funds See Worst Performance in Five Years

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Amid the impact of the interest rate cut cycle and changes in market conditions, U.S.-listed Business Development Companies (BDCs) are facing their worst annual performance relative to the S&P 500 index since 2020, prompting investors to reassess the outlook for such assets in the $1.7 trillion private credit market.

According to data compiled by Bloomberg, as of December 24, the Cliffwater BDC Index—which tracks 41 direct lending investment vehicles—has fallen about 6.6% this year, a sharp contrast to the 18.1% rise of the S&P 500 index during the same period. In 2023 and 2024, this BDC index had seen increases of 25.4% and 14.1% respectively.

Against a backdrop of the Federal Reserve preparing to continue cutting rates next year and a lack of private credit transactions narrowing lending profit margins, BDCs are experiencing a triple blow: expectations of rate cuts, market shocks, and rising signs of stress.

The shift in market sentiment has directly impacted investor confidence and money flows. Some large funds are under increasing pressure from redemption requests, forcing the industry to reevaluate return expectations: the era of double-digit returns may be ending and replaced by mid-to-high single-digit levels.

Poor performance triggers investor skepticism

So far this year, BDCs have significantly underperformed the market, raising widespread doubts about this asset class. Matt Malone, Head of Investment Management at Opto Investments, said clients are skeptical as to whether large, broadly distributed investment vehicles can maintain their past level of returns.

Over the past year, the private credit market has expanded and matured, starting to undertake blue-chip AI infrastructure projects and more investment-grade debt. This shift is forcing investors to consider whether this remains the best risk-adjusted way to invest in private credit for clients. Although firms such as Blue Owl Capital Inc., Ares Management Corp., and Blackstone Inc. have for months tried to reassure investors that their portfolios remain healthy and their share prices have suffered unfair punishment due to broad credit market shocks, market doubts persist.

Although data from Moody's shows that fundraising for non-traded private credit funds has remained stable over the past year—for example, Blackstone's non-traded fund BCRED raised $2.8 billion in new net equity in Q3, and Blue Owl's OCIC absorbed $1.9 billion—redemption requests are rising for some large institutions.

In November, redemption requests for Blue Owl's BDC product OBDC II exceeded 5% of the fund’s net asset value. At the same time, Blackstone Private Credit Fund is expected to see Q4 redemption requests reach 4.5% of net asset value as of September 30.

Additionally, the decline in BDC share prices has disrupted some managers’ strategic plans. Blue Owl attempted to merge its smaller private fund, Blue Owl Capital Corp. II, into its larger, publicly traded OBDC, which was trading at a ~20% discount to net asset value at that time. However, after scrutiny over the potential losses investors could face, the company withdrew the plan within days.

Narrower spreads weigh on return expectations

Looking ahead, as the Federal Reserve continues to cut rates next year, private credit managers must work harder to convince investors that BDCs are still worth investing in. According to Wells Fargo & Co. data, the average spread on private credit transactions has narrowed from 650 basis points in Q1 2023 to under 500 basis points (over benchmark). Davidson Kempner’s Managing Partner and CIO, Tony Yoseloff, stated:

"The issue is that direct corporate loans have long been touted as a double-digit return asset class, but that’s no longer true today."

He said that as returns drop, this asset class will increasingly look like a mid-to-high single-digit product.

Given tepid investor responses to BDCs, private credit managers have started launching perpetual private investment products such as interval funds. These funds allow for continuous fundraising without the headache of share price volatility.

Christopher P. Healey, partner at Davis Polk & Wardwell, considers interval funds a "second-generation product" after BDCs because they’re more investor-friendly and provide better liquidity. By rule, interval funds must offer regular redemption services to investors.

Moreover, these structures can accommodate products that typical BDCs cannot, such as investment-grade private credit and asset-backed financing—areas that managers are now seeking to expand. Bill Bielefeld, co-head of permanent capital at Dechert, said that as attention turns more broadly to private credit, investors want access not only to direct loans, but asset-backed financing and other products more suited to interval funds than BDCs.

Short sellers and signs of credit stress

The BDC market’s weak performance has attracted the attention of short sellers. According to data from research firm S3 Partners, this year, total short positions against 47 publicly traded BDCs amounted to about $1.83 billion, with over $500 million in new shorts—a 38% increase over a year ago. Traders have made mark-to-market profits of about $132.7 million, up roughly 7% year-on-year.

Short sellers are focusing on growing signs of stress in the private credit market. According to Raymond James data, payment-in-kind (PIK) interest income—a signal that borrowers are unable to pay cash—has been trending higher in BDCs, reaching 7.9% in Q3. At the same time, 3.6% of BDC investments were on non-accrual status, a metric indicating lenders expect losses.

Amid mounting pressure and scrutiny, some lenders see this as a chance to prove their skill. Kort Schnabel, Co-Head of U.S. Direct Lending at Ares, said: "Only when the entire industry experiences credit weakness does the importance of manager selection become truly clear. We think this trend is just beginning to appear."

Risk Warning & DisclaimerThe market has risks; investment needs caution. This article does not constitute personal investment advice and does not take into account the unique investment objectives, financial circumstances, or needs of any particular user. Users should consider whether any opinions, viewpoints, or conclusions in this article suit their specific situation. Invest accordingly at your own risk. ```