Back to Basics on BDCs
On BDCs and public investors: opportunity costs, liquidity mismatch, and prisoners' dilemma
In introductory economics, the first thing we are taught is the definition of the word itself; “Economics is the study of how individuals and societies allocate scarce resources among competing needs.” The word scarce here carries some weight, and in our post-keynesian world, often gets pushed to the back. This (efficient) allocation of these scarce resources introduces us to the concept of opportunity cost, that is, the value of the next best alternative that must be given up when allocating for the said scarce resource.
In public markets this is observable, as based on information and new information, we allocate and reallocate our resources to securities where the risk-adjusted returns are the highest. This in essence is the Efficient Market Hypothesis.
If there are better opportunities available for our scarce resources, then either we sell our current investments to reallocate and keep on the path to maximizing our returns, or we convince ourselves to stick with the current ones and be okay with accepting a lower risk-adjusted return. If we choose to justify sticking with this current lower risk-adjusted return, it’s possible that other investors might not agree with us, which will lower the value of our holdings even further leading to even lower returns. In this case, these public, liquid markets (at least in the short term) provide an incentive for everyone, even the unwilling, to incorporate and act on this new information and move to securities with better returns.
On the other hand, for private markets, we assume we have (as Matt Levine calls it) a safe funding model, meaning that as money managers when we allocate capital for 7 years and expect to have to give it back in 7 years, then during that entire time period, we can in theory choose to mark it to wherever we want. We might even have reasons to do so; we believe that market fluctuations are either temporary or not relevant to our long-term returns, so there’s no need for constant marking and re-marking of those assets. It might not be prudent to do it this way, it might not even be a responsible thing to do, people might question and object to it, but we can do it should we choose. There’s almost an inherent incentive to not sweat the constant short-term fluctuations.
But if we are thinking this way, in a large enough market, chances are other allocators like us are thinking the same way. And statistically, some of these marks will turn out to be way off the mark.
“BlackRock Inc. slashed the value of a private loan to zero at the end of 2025, just three months after assessing it at 100 cents on the dollar, marking the second sudden wipeout to recently hit its private-credit division.
The roughly $25 million loan to Infinite Commerce Holdings, a so-called Amazon aggregator that buys up online sellers of products from spa treatments to light bulbs, is now worthless, BlackRock TCP Capital Corp. reported in fourth-quarter filings released last week.” From last November:
“About a month ago, BlackRock Inc. deemed the private debt it had extended to Renovo Home Partners, a struggling home improvement company, to be worth 100 cents on the dollar. As of last week, the firm had a new assessment: zero.”
“But the company benefited from another set of lenders that are now asking to be paid back: Private credit. These firms gave First Brands its last infusion of cash before its collapse, an unraveling that capped weeks of investor concern about the company’s use of opaque, offbalance-sheet financing.”
Even if we believe these headlines are anomalies or are statistically insignificant to overall portfolio returns, it’s not unreasonable to assume that investors will look at this market and wonder, ‘wait, what’s really going on here?’ and ‘how rational is it for me to feel psychologically safe right now?’
As a private investor in these private markets, the prudent thing for me to do here is to try and perform my own due diligence on the investments and their current marks. From here I can have either of these conclusions:
A. The marks are fine. I believe these headlines do not show that this is systematic, or correlated to our holdings, and anyway I have time on my side, I’ll wait this out i.e hold to maturity. Nothing to worry about for now. I still believe the illiquidity premium exists and is worth it.
B. The marks for my allocations are completely fine, and not only does the market has it wrong, it has it so wrong that the underlying assets are now undervalued and I am going to go for it and allocate even more below par value.
C. The marks are really off. The market is right to panic, and also there’s some other weird issues around this private credit thing. But, as a private investor I don’t have much leverage here but to wait it out till maturity and hope to be repaid in full at the end. It’s very possible every new headline might cause me some sleepless nights, and I might conclude that this wasn’t a great experience (or it was in the past but now has run its course). In any case, in the future I will reallocate my scarce resources accordingly, i.e. away from private credit.
As a public investor in these private markets, however, is where things get interesting. This is where we get retail investors matched to private funds through publicly-listed BDCs. As a retail investor, I see these headlines and I see these redemption requests, and I conclude with one of the only two ways, that either:
A. I believe the marks are fine. I can choose to stay invested or allocate even more and keep collecting some nice dividends. Or,
B. I believe the marks are really off. I want out.
The issue here (back to where we started from), is that if I choose to stay invested, others might not think that way. And in the event that more of my fellow retail investors decide they want out vs. those like me who choose to stay invested, the buy-sell disequilibrium will inevitably lead to a sell-off and the value of my investment going further down. Here too, I will have to reason with myself (much easier in theory) to stick with the current lower value of my investment and accept a lower risk-adjusted return.
Is that the right thing to do? Does it even really matter whether I think the sell-off in public BDCs is due to perceived risk to growth multiples for underlying assets or just mere market hysteria? One could argue, based on the limited redemption structure of public BDCs, the right thing to do is to rush to the exits, and rush to the exits as soon as possible, because the resources might just be getting a lot scarcer.
This dilemma, to stay invested or get out of publicly-listed BDCs today, is essentially whether to make a bet on efficient market hypothesis or game theory.