Business development company (BDC) equities are signaling growing investor skepticism over private credit valuations, even as BDC bonds have recovered much of their recent underperformance. 

The divergence suggests investors are demanding a higher risk premium to compensate for uncertainty about the value of loans held by BDCs, which finance small and midsize private U.S. companies.

According to a report by Lotfi Karoui, Multi-Asset Credit Strategist and Co-Head of Client Solutions and Analytics at PIMCO, the performance gap between BDC bonds and equities is largely an asset-valuation story. Bondholders have claims on the underlying assets, while equity investors are increasingly questioning whether reported net asset values accurately reflect the value of portfolio holdings.

"Equity investors are increasingly focused on the credibility of reported net asset values," Karoui said, adding that the skepticism is unlikely to ease without a better mechanism for price discovery.

A broader valuation reset in private credit has yet to occur in earnest, Karoui added. More than two quarters after redemption pressures began weighing on semi-liquid direct-lending vehicles, and despite increasing signs of financial distress in parts of the market, BDC portfolios have shown "limited evidence of a meaningful markdown."

Loan marks remain elevated both in absolute terms and compared with the broadly syndicated loan market. The gap between BDC valuations and publicly traded leveraged loans has widened, particularly at the lower end of the price distribution.

Similar divergences emerged during periods of acute market stress, including the Covid-19 shock and the 2022 Russia-Ukraine war and the subsequent interest-rate-hiking cycle. But Karoui noted that the current episode is unfolding against a backdrop of relatively benign market conditions and low levels of systemic stress.

The strategist also highlighted pressure on another source of BDC returns: the premium earned on new direct-lending deals.

Deals originated in 2017 and 2018 offered BDCs an average spread advantage of more than 300 basis points over leveraged loans. By the first quarter of 2026, that advantage had fallen to less than 100 basis points, according to Karoui.

The compression means the economics of deploying new capital through private credit are becoming increasingly similar to those available in public markets. That could make it harder for BDCs to generate excess returns while existing portfolios remain valued at relatively high levels.

Private Real Estate: A Potential Precedent?

During the 2022 market dislocation, private real estate vehicles initially resisted declines in publicly traded REITs before valuations eventually converged through a combination of public-market recovery and private-market markdowns.

A similar outcome cannot be ruled out for BDCs, Karoui said, although the adjustment could take longer. Bank credit facilities, principal repayments and liquid assets provide BDCs with tools to manage liquidity needs and potentially delay markdowns.

Still, Karoui warned that if private-credit valuations eventually move closer to where comparable risks are priced in public markets, BDC equities could face further pressure.

The split between stronger BDC bond performance and weaker equity performance therefore points to a growing divide in how investors view private credit: Credit markets remain relatively resilient, while equity investors are increasingly questioning whether reported valuations fully capture the risks in BDC portfolios.

Photo: AI image created using ChatGPT