Market Discipline in the Direct Lending Space

Abstract

Using the exclusion of business development companies (BDCs) from stock indexes, this paper studies the efficacy of market discipline in the direct lending space. Amid share sell-offs by institutional investors, a drop in valuations limits the ability of affected BDCs to raise new capital and sustain their investment activity. Due to market discipline, affected BDCs reduce the risk exposure of their portfolios by shifting towards senior debt. The contraction in BDC credit hampers employment growth of their portfolio companies. The certification channel allows affected borrowers to partially offset this effect by diversifying across lenders and securing funding from new BDCs.

Keywords: business development companies, nonbank lending, market discipline, index exclusion, capital supply shock, real effects

JEL Classification: G20, G23, G28