The Illiquidity Illusion: What Broke Blue Owl's OBDC II

Blue Owl Capital has been the posterchild of private credit for years (until this week), amassing a staggering $157.8 billion in credit AUM.¹ The firm originated in 2021, following the merger of Owl Rock Capital Group and Dyal Capital Partners. Owl Rock is responsible for the credit division of Blue Owl. It was formed in 2016 to claim the premiums being paid to middle-market lenders after the big banks ceased lending to these clients following the 2008 financial crisis.

What Happened

In the past week, Blue Owl has been under scrutiny as it was forced to sell 34% of its private credit fund, OBDC II, and permanently suspend redemptions due to a mass withdrawal of capital by investors. Many believe that this occurred as a result of investor doubt in private credit safety, brought on by high-profile defaults (specifically BlackRock's TCPC fund²), but this is not the case. OBDC II is a BDC 2.0 fund. Blue Owl raised capital through this vehicle, and the intention was to merge the fund with their publicly traded BDC, OBDC, for a clean exit. Blue Owl attempted to execute this strategy, but a fundamental flaw arose: what happens when the public BDC isn't trading at NAV?

A Familiar Echo

It is interesting to consider that private credit was born from the consequences big banks faced following the GFC. This situation is somewhat reminiscent of the irresponsible financial engineering in 2008. The creation of AAA-rated CDOs using tranches of hundreds of subprime mortgages allowed banks to sell investment-grade assets comprised of risky "junk" assets. While the diversification may have limited idiosyncratic risks, the underlying assets still had large exposure to systemic risks, meaning the CDOs were vulnerable to the same systemic risks. Ratings agencies ignored these fundamental risks in the assets and gave them a AAA rating. For most investors, the rating is sufficient to buy the assets and hold without worry.

This is strikingly similar to the events experienced by Blue Owl. Blue Owl marketed non-liquid assets as liquid simply by saying investors could redeem 5% of their capital quarterly. An apple is an apple and will always be an apple. Investors saw that they could redeem their money and did: it broke the fund. This is similar in spirit to investors believing their mortgage assets were safe in 2008 because the ratings agencies said so.

Two Perspectives

1. Institutions are incentivized to raise more capital as this increases their fees, so they claimed their private credit assets were liquid to give access to these funds to retail investors and wealth management clients.
2. Retail investors are feeling greedy after the last 3 years' returns. This drove them to demand a liquid vehicle to experience the high risk-adjusted returns of middle market direct lending.

In the first case, Blue Owl's mishap will recur, and further light will be shed on the reality of these funds. Once that happens, redemptions will rise, funds will be forced to liquidate, and the non-traded BDC model will die. Non-public to public BDCs and incentive structure changes would follow to correct the market for private credit funds.

As to the second case, retail investors must step back and consider their investments objectively. When compared to broadly syndicated loans, private credit may have slightly higher credit risk as the businesses are smaller, and the loans are illiquid. Morningstar³ suggests that middle-market loans are actually less risky according to data from 1995-2022. This leaves an illiquidity premium separating the two asset classes, which J.P. Morgan supports being priced at 200-300bps.⁴ Without the liquidity premium, investors may as well buy BSLs. The capital would then be entirely liquid, and these events would not occur.

Where This Leaves Private Credit

I personally believe the second case is more likely. The unfortunate flaws of the BDC 2.0 model have mostly been corrected in the more popular and current BDC 3.0. This is a perpetual non-traded model that retains the 5% quarterly redemptions (or some other equivalent). Since institutions popularized this model that has less inclination towards liquidity, it would suggest that the greater part of the disconnect that caused the Blue Owl event was on the investor side.

For investors who remain wary of private credit after the events, consider this: Blue Owl suffered no more than a fundamental issue in the legal structure of their fund. The error has already been fixed in the BDC 3.0 model. So long as the widespread coverage of this occurrence signals to investors that direct loans are an illiquid asset and must be treated as such, the unfortunate events of OBDC II will not occur again anytime in the near future. As to those who have paused to think about the best way to leverage the BDC 3.0 structure, use the redemptions to constantly optimize your portfolio according to short-term fluctuations in the market, but do not assume that your capital can be withdrawn using these redemptions. The growing secondaries market is where a new form of liquidity will arise (more on secondaries in the near future).