The problem with large BDCs

Problem 1: Overpriced

Business Development Companies (BDCs) frequently promise a clean 10% return through reliable income, paired with impressively low volatility. It is an easy pitch - no wonder they have exploded in popularity. 

But if these mega-BDC lenders, writing huge loans to firms that frequently could just tap public markets, truly offered such an amazing risk/reward, why does everyone not flock to them? And if managers genuinely believed in their own sky-high Sharpe ratios (often above 1.75, even 3.0 for some - while top hedge funds typically hover around 1.0), why would they sell this golden goose to the market for less than the usual “2 and 20” fees?

Mega-cap BDCs have run on a hypergrowth story for years, but we see overpriced beta with hidden risk that only shows up when you’re forced to sell. Forced sales typically happen when markets are in turmoil or investors are pulling money - exactly the worst time to discover that the emperor has no clothes.

BDC versus high-yield: the real differences

BDCs and high-yield bonds often share similar borrowers and deal structures, yet there are clear differences in how each gets priced and reported.

A simple loan return formula

Any pool of loans boils down to three return components:

1. Coupon payments

2. Changes in yield (i.e., gains/losses from shifts in spreads)

3. Defaults and recoveries

High-yield (HY) bonds are typically longer term (five-to-seven years), priced off longer-dated Treasury yields, and constantly valued by the market. BDC loans, on the other hand, are usually floating rate, pegged to short-term interest rates, and not continuously marked to market.

The BDC formula looks more like:

1. Coupon = 3-month Treasury + spread

2. Return = Coupon + duration * change in spread

3. Defaults? So far, they’ve been rare, so we will ignore for now

“Houston, we have a marking problem”

While HY bonds get daily scrutiny from the market, BDC loans are updated only sporadically - in theory quarterly, but in practice as few as 25-35% of positions get revalued. On average, just 30% of a BDC’s book sees any “material” price change quarter-to-quarter. This is a big reason BDC volatility appears so low.¹

The result? BDCs let investors collect coupons without frequent mark-to-market drawdowns. Look at FS KKR BDC before and after going public: once the market started pricing it regularly, volatility jumped, and the “steady” returns gave way to more realistic swings (see chart).

Leverage: a manager’s best friend

BDCs also often use leverage, typically in the 1.5x to 2.0x range. Coupled with infrequent marking, managers can “juice” spreads while barely increasing reported volatility. This is a sweet deal for short-term optics, but it disguises risk.

Putting it all together

It is surprisingly easy to replicate large-cap BDC performance using public markets:

• Start with high-yield bonds, convert them to floating-rate exposure

• Layer on about 50% leverage

• Reprice only 30% to 40% of the loans each quarter

Running this approach from 2020 to now explains 88% of the variance in large BDC performance (see chart below). In fact, the replication slightly outperforms most BDCs - likely because of hefty fees. These large BDC managers typically charge a 1.25% to 1.5% management fee plus 12.5% carry, on top of other expenses that can add up to another 0.25% to 1.5%. Meanwhile, you can assemble the building blocks (T-bills, credit spreads, leverage) far more cheaply in public markets (see chart).

If you do a fully marked-to-market replication at 1.5x leverage (no partial quarterly re-marking), you’ll see more price swings - but end up in roughly the same place return-wise (minus some volatility drag). We would argue that the choppier path is the real economic experience. The minimal volatility investors in large BDCs see is largely an artifact of irregular marking.

The most important thing

All this suggests large BDCs, in general, offer little true diversification or alpha. In fact, they appear to be leveraged credit exposure with artificially smoothed volatility.

Correlations are telling (see chart):

• The average pair-wise correlation between the largest private BDCs is 85%

• Between public BDCs the correlation is 75%

• The correlation of large BDCs to the simple replication strategy is 80% (private) and 76% (public)

In a market environment that is increasingly uncertain, why pay fees for something that claims to be a stable, alpha-producing strategy, but is basically leveraged credit exposure with no real alpha or diversification benefits?

Investors deserve better, and they can find it in the evolving private markets. If it looks too good to be true and holds billions in AUM, odds are the real economics are not what they claim. Never settle.

- Jacob Miller, Chief Solutions Officer

Problem 2: Undifferentiated

Private credit has come a long way since the GFC - back then there were a handful of traded BDCs and the non-traded market was beginning to emerge. The idea of packaging a book of “directly originated” loans and allowing investors to “be the bank” was new and exciting. Fast forward to 2025, and nearly every asset manager is leaning into the sector and money has flooded into the market.

However, with the explosion of private credit funds, it has become harder to differentiate between managers - particularly at the upper end of the market (see chart). 

Looking under the hood at some of the largest managers’ private/evergreen BDCs (Apollo, Blackstone, Blue Owl and HPS), the portfolios are strikingly similar. All count software and healthcare as two of three largest sector exposures, lend to companies with a very similar average EBITDA of $240M, and all hold about 15% of their portfolios in their top ten companies. Even more to the point - there is overlap down to the individual company level - just across these four funds.

What does this mean for investors? If the goal is to build a diversified portfolio of private credit, you probably need to look beyond the large BDC market.

- Matthew Malone, Head of Investment Management

Get in touch with us to discuss alternatives to large BDCs for credit exposure, at partner@optoinvest.com.