One of the structural features of private credit that makes it attractive to allocators — the absence of mark-to-market volatility — also makes it nearly impossible to assess in real time. Business Development Companies are different. They are listed on public stock exchanges, and their shares trade every day at prices set by the market. This creates an observable tension: the NAV the manager reports each quarter, and the price the market is willing to pay for that NAV. When that price is a persistent discount, the market is saying, with money behind the assessment, that the reported values overstate the reality.
II. What BDCs Are and How They Work
A BDC is a regulated vehicle for private credit investing that must distribute at least 90 percent of its taxable income to shareholders and must invest at least 70 percent of its assets in qualifying private companies. Since the 2018 Small Business Credit Availability Act, BDCs can operate with debt-to-equity ratios of up to 2:1.
The largest BDCs — Ares Capital Corporation, Blue Owl Capital Corporation, FS KKR Capital Corp, Prospect Capital — collectively manage tens of billions in middle-market loans. They are also heavily retail-facing. Unlike closed-end direct lending funds available only to qualified institutional investors, BDCs can be purchased by any investor with a brokerage account. Dividend yields of 10 to 14 percent in the 2022 to 2024 rate environment attracted significant retail inflows.
The manager earns fees on assets under management, typically a base management fee of 1.5 percent of assets plus an incentive fee on income and gains. The incentive is to grow the asset base and maintain NAV marks that support fee income. The shareholder wants to know what the portfolio is actually worth and whether the dividend is sustainable. These interests diverge when credit quality deteriorates.
III. What the Market Is Pricing
A well-managed BDC with a high-quality portfolio typically trades at or above NAV. When BDCs trade at persistent and widening discounts to NAV, the market is expressing a specific concern: that the reported NAV overstates the true value of the loan portfolio. The discount is the market's estimate of the expected future write-downs.
Several of the larger BDCs have traded at discounts to NAV that have widened through 2023 and 2024, even as managers reported stable or improving credit metrics. This divergence is precisely what one would expect at the stage of a credit cycle when deterioration is beginning to appear in the underlying portfolio but has not yet been fully reflected in manager marks.
The ABX indices, which referenced subprime mortgage bonds, began selling off in late 2006, several months before rating agencies downgraded the underlying bonds and well before the banks acknowledged meaningful losses. BDC share prices are playing a similar role today. They are the ABX of private credit.
IV. The PIK Problem and Dividend Sustainability
PIK income is not cash. It is the accrual of interest that the borrower is adding to the loan principal rather than paying in cash. From an accounting perspective, PIK income counts as earned income and can be included in the net investment income that supports the BDC's dividend. From a credit perspective, a borrower that cannot service its debt in cash is a borrower under stress.
Several BDCs have reported increases in PIK income as a percentage of total income through 2023 and 2024. When PIK income is supporting a portion of the dividend being paid to shareholders, the dividend is, in effect, being partially funded by deferred losses. The shareholder receives a cash payment today that is offset by a deteriorating asset on the other side of the balance sheet.
V. The SVB Lesson and Its Application
The collapse of Silicon Valley Bank in March 2023 was, at its core, a lesson in what happens when the duration and liquidity assumptions embedded in a portfolio are stress-tested by a change in the external environment that nobody had adequately modelled. SVB's portfolio was not composed of bad assets. The problem was the mismatch between the duration of the assets and the duration of the liabilities. The held-to-maturity accounting obscured the losses that were accumulating.
The mark-to-model accounting in BDC portfolios serves a similar function. BDCs do not have deposit liabilities, but the structural lesson applies: when the market loses confidence in the NAV marks, the share price falls, the cost of equity capital rises, and the ability to grow the portfolio through new equity issuance is impaired. The deeper SVB lesson is about the gap between reported values and economic reality. It does not make the losses real — but it delays their recognition, and in doing so it delays the market's ability to price the risk accurately.
VI. The Asia Lens
Several large Japanese insurance companies and regional banks have been among the buyers of BDC paper and US middle-market CLO structures as part of their search for yield in a domestic zero-rate environment. A deterioration in BDC marks flows through to these portfolios, and the opacity of the exposure makes it difficult to assess the full extent of the impact from outside.
India's NBFC sector and certain segments of Korea's non-bank financial system occupy structurally similar positions to BDCs in their respective economies. They intermediate credit to borrowers underserved by the formal banking system, hold assets that are less liquid than their funding in some cases, and operate in an environment where rapid growth has sometimes outpaced underwriting discipline. What happens in the visible part of a credit system is usually a preview of what happens in the less visible parts.
The third piece in this series places both the private credit boom and the BDC stress in their proper historical context, through the lens of a practitioner who watched the 2006 to 2008 cycle unfold in real time and finds the current sequence of events uncomfortably familiar.