The BDC financial report reveals the hidden trend of private credit in the United States: overall stable, but cracks are spreading.

Concerns about the US credit market have been lingering since the beginning of this year, particularly regarding the private credit market which appears fragile and opaque compared to the banking system. As a crucial bridge connecting small and medium-sized enterprises with private credit capital, several Business Development Companies (BDCs) that announced their financial reports earlier this month are seen as important windows into the health of the private credit market amidst escalating market concerns. While these reports reflect overall stability in the private credit market, warnings from market participants indicate that vigilance cannot be relaxed easily. Overall Stable but Under Pressure Locally Business Development Companies (BDCs) specialize in gathering private credit resources for various small and medium-sized enterprises that often struggle to secure financing through traditional capital markets. President of CEF Advisors, John Cole Scott, has stated that the latest financial reports of BDCs essentially provide real-time stress tests for private credit. Compared to banks, the financial reports of BDCs can offer more timely credit data. Data shows that Blue Owl Capital (OBDC.US) had a third-quarter net investment income of $190.1 million, falling short of analysts' average expectations; while Ares Capital (ARCC.US) had a third-quarter net investment income of $338 million, also falling below expectations. Main Street Capital (MAIN.US) and FS KKR Capital (FSK.US) reported net investment incomes of $86.5 million and $159 million in the third quarter, respectively. Additionally, the dividends of these BDCs remain stable. At the same time, one of the most crucial indicators for assessing the credit quality of BDC investment portfolios - the percentage of non-accrual investments (measured by fair value) - are showing a relatively favorable situation. As of the end of the third quarter, Main Street Capital and FS KKR Capital had percentages of non-accrual investments at 1.2% and 2.9% respectively, both lower than the percentages at the end of the second quarter of 2.1% and 3.0%. However, Blue Owl Capital's performance in this key indicator has been poor, nearly doubling from 0.7% at the end of the second quarter to 1.3% at the end of the third quarter. A lower and stable percentage of non-accrual investments typically indicates the overall health of a BDC's borrowers. Conversely, a rising percentage of non-accrual investments is a clear danger signal, indicating deteriorating asset quality and a higher risk of default for more loans. It is worth noting that many of the new listings of non-performing assets in the BDCs' third quarter involve consumer-oriented business loans. After Carlyle Group Inc. BDC added Roomba manufacturer iRobot Corp. to its list of non-performing assets, the company has revised its credit agreement for the sixth time in August. Blue Owl BDC listed loans for online health insurance platform GoHealth Inc. and wig supplier Beauty Industry Group as non-performing assets, causing its percentage of non-performing assets in the third quarter to rise to 1.3% of the investment portfolio, nearly doubling from 0.7% at the end of the second quarter. FS KKR took over live event company Production Resource Group after restructuring in October. Ares Capital, as an industry leader, maintains a low percentage of non-performing loans and strong issuance of new loans, demonstrating its risk management capabilities and resilient asset selection. Main Street Capital continues its conservative strategy, with over 85% of high-rated assets in its investment portfolio and a dividend coverage ratio of over 1.3 times, showing strong countercyclical ability. In contrast, FS KKR faces greater challenges. Its financial report revealed that some positions related to consumer finance and subprime auto loans faced fair value markdowns, resulting in an increase of approximately $18 million in impairment provisions in the third quarter compared to the previous quarter. Although management emphasized that "default rates remain within manageable range, concerns were expressed in the market regarding its high concentration of assets. BDC Stock Prices Under Pressure Reflecting Market Confidence, Potential for Greater Pressure Next Year BDC stock prices have been under pressure throughout this year, with the S&P BDC Index significantly underperforming the broader stock market. Jefferies Financial Group Inc. analyst John Hecht pointed out that BDCs generally hold a large amount of floating rate loan assets. In the context of expectations of interest rate cuts by the Federal Reserve, their future interest income faces compression, reducing dividend attractiveness and triggering a revaluation. Additionally, market concerns about credit risks in BDC investment portfolios have intensified selling pressure. A report released by rating agency Fitch Ratings on Wednesday indicated that as spreads further narrow, and the size of Payment-in-Kind (PIK) payments is expected to increase, publicly traded Business Development Companies (BDCs) may face greater pressures next year. Earlier this month, Fitch had already downgraded the outlook for BDCs to "deteriorating", citing the long-term existence of asset quality pressures due to challenging economic environments. Fitch noted that the rate cuts are another focus of concern for investors, and these could lead BDCs to further cut dividends over the coming quarters. As dividends decline, the leverage and liquidity levels of BDCs are likely to decrease, testing the tolerance for mechanisms such as PIK. PIK permits borrowers to defer interest payments until the debt itself is repaid. This mechanism books interest as part of the loan principal instead of cash payments, which can enhance the lending partys performance while providing temporary buffer for the borrower. However, the continued expansion of this high-cost debt raises concerns in the market that private credit funds may be masking deteriorating loan quality through PIK. Nearly half of the market participants surveyed by Fitch, including fixed income investors, banks, and BDCs, expect an increase in the size of PIK in 2026. However, respondents emphasized the importance of distinguishing between "benign PIK" and "distressed PIK". Fitch's report pointed out that while "benign PIK" structured in the design phase can enhance returns and provide flexibility, PIK added during restructuring or adjustments in terms may "lead to increased ultimately distressed assets and losses". Although interest rate cuts may alleviate the need for such flexible mechanisms by borrowers, Fitch believes that "PIK will remain high, as fund managers are accustomed to this choice. Private Credit Market Risks Lurking Federal Reserve Governor Lael Brainard stated on Thursday that officials should monitor how unexpected losses in the private credit market could spread to a broader financial system given the increased complexity and interconnectivity of leveraged firms. Brainard expressed concern about the use of PIK arrangements that have been evident from recent bankruptcy cases. She said, "When the scale and complexity of these arrangements lack transparency, when an industry experiences rapid growth, and when these arrangements have not yet been through a full credit cycle, we are more likely to see cases similar to what has recently been reported. Brainard also pointed out that recent bankruptcies in the private companies in the automotive industry have exposed unexpected losses and exposures in a broad financial entity, including banks, hedge funds, and specialty finance firms. Her remarks echoed concerns voiced by Fed Governor Christopher Waller earlier this week that he views private credit as a potential area of risk. However, Brainard also noted that despite the high valuations of assets and the complexity of the private credit market, as well as the potential fragility that hedge fund activities could lead to disruptions in the government bond market, the financial system remains resilient. In contrast, DoubleLine Capital founder and Bond King Jeffrey Gundlach's warnings about the private credit market were more pointed. He recently stated that the $1.7 trillion private credit market is engaging in "junk lending," with speculative behavior reminiscent of the eve of the 2006 subprime crisis, and may trigger the next global market downturn. As a seasoned bond investor, Gundlach is particularly concerned about the expansion of private credit funds to retail investors, creating a "perfect mismatch" between liquidity commitments and illiquid assets. He even predicts that the next major financial market crisis will come from private credit, which exhibits characteristics similar to the repackaging of subprime mortgages in 2006. Gundlach's concerns are not unfounded. The bankruptcies of auto loan firm Tricolour and auto parts supplier First Brands serve as evidence of the risks accumulating in the private credit market. BlackRock, Inc. recently wrote down the value of its loan to home improvement company Renovo Home Partners from face value to zero. Furthermore, as a prominent player in the US private credit market, Blue Owl's recent setbacks have also revealed cracks in the market. This Wednesday, Blue Owl suddenly announced the cancellation of the merger plan for two of its private credit funds, leading to its stock price falling to its lowest point since 2023. The planned merger was intended to combine a private fund into the publicly listed Blue Owl Capital Corp., but concerns over potential losses of up to 20% for investors triggered a strong market reaction and regulatory scrutiny. Even more worrisome is the emerging liquidity pressures. Redemption requests for the involved private funds have surged, with approved redemption amounts totaling approximately $60 million in the third quarter, exceeding the preset limit. Although Blue Owl has promised to resume redemptions in the first quarter of next year after the merger termination, there are concerns in the market that if redemptions continue, funds may be forced to restrict outflows of capital. Another US private credit giant, Capital One, has also faced selling pressure due to the rising non-performing asset ratio - insider sell-offs and an increase in the provision for bad loans (a 42 basis point increase, far exceeding the seasonal norm of 19 basis points) are warning signs for the market. Rich Privorotsky, Head of the Delta-One division at Goldman Sachs Group, Inc., bluntly stated in a recent report, "Perhaps we should pay more attention to Blue Owl and Capital One." He pointed out that as the market revels in the prosperity of tech stocks, pressures of the "K-shaped economy" are becoming apparent - not only is Blue Owl facing investor withdrawals, but Capital One in the consumer finance sector is also experiencing stock declines due to a rise in non-performing asset ratios. This illustrates that from institutional credit to personal credit, the underlying assets of the US credit system are bearing the delayed impact of a tightening monetary cycle. Although firms like Morgan Stanley project a $1.5 trillion financing gap for AI infrastructure in the coming years, with around $800 billion expected to be filled by private credit, the current market turbulence suggests that private credit may be the most fragile link in this grand narrative. The concern is that the market widely fears that interest rate cuts will compress the returns on private credit loans, while economic slowdown may increase the risk of default for small and medium-sized enterprises, leading to deteriorating asset quality. Joint Chief Investment Officer of Sixth Street Partners, Josh Easterly, has warned that amid anticipated rate cuts, private credit returns across the industry will no longer exhibit the brilliance of the past few years. In conclusion, the third-quarter BDC financial reports reflect the true picture of the US credit market under the intertwining shifts in interest rates and economic slowdown: overall manageable, but structural vulnerabilities are emerging. The risks revealed in BDC financial reports are a microcosm of the multiple pressures at a macro level. Pressures are rising for small and medium-sized enterprises as the debt burdens accumulated in the past two years continue to erode corporate cash flows (particularly for subprime borrowers relying on short-term funding). With a backdrop of slowing revenue growth, debt servicing capacity is noticeably weakened. Additionally, the linkages between banks and private credit are deepening - industry data shows that about 30% of BDC funds come from bank partnerships or structured financing arrangements. If credit risks further spread, they could be transmitted to the traditional banking system through these partnership channels. Investors need to closely monitor changes in the debt servicing capacity of small and medium-sized enterprises, the evolution of asset quality in BDCs, and the risk transmission between banks and private credit. Although short-term market fluctuations are unavoidable, the likelihood of a systemic crisis remains relatively low unless there is a major shock. However, as history repeatedly reminds us, credit risks often accumulate quietly in calm times, and the real test may still lie ahead.