Introduction
Business Development Companies (BDCs) have recently experienced a boom, representing a major expansion in the US middle-market lending and private credit markets. In fact, BDCs now manage approximately $478bn and provide about a quarter of all “direct lending” to US companies. Their growth has bridged the gap left by banks retreating from middle-market loans, offering investors double-digit yields through leveraged exposure to private borrowers. However, this expansion has also magnified risk. The September 2025 bankruptcy of First Brands Group exposed how borrower distress can resonate through the BDC ecosystem. While not a systemic threat, it emphasized that high leverage and limited transparency leave BDCs vulnerable in downturns.
BDCs’ History and How they Operate
BDCs hold a “hybrid position” between regulated investment funds and nonbank lenders. They are closed-end investment companies that raise money from investors and channel it into small and mid-sized US businesses, typically those too small to issue public debt. BDCs were created by the US Congress in 1980 through an amendment to the Investment Company Act of 1940 and were intended to democratize access to private market returns and expand financing for smaller enterprises. To qualify, at least 70% of assets must be invested in US “eligible portfolio companies” valued below approximately $250m.
Although they specialize in private credit, BDCs operate with the transparency expected of public investment vehicles. They file regular disclosures with the Securities and Exchange Commission, and their organizational structure resembles that of pass-through entities such as REITs. By distributing at least 90% of taxable income to shareholders, they avoid corporate taxation and generate comparatively high cash yields. Their regulatory framework also limits leverage through a 2:1 debt-to-equity cap, though most BDCs make significant use of bank credit lines or bond issuance to increase investor capital and their lending activity.
An important feature of BDCs’ income generation in recent years has been the growing use of payment-in-kind (PIK) interest. This allows interest to accrue rather than be paid in cash, and its rising prevalence has become a point of debate within the private credit industry. In some BDCs, PIK interest now accounts for more than 15% of gross investment income, and industry estimates suggest that nearly a fifth of BDCs derive over 10% of their income from PIK accruals. This is significant, as BDCs must distribute almost all taxable income, including noncash PIK earnings, which may require raising debt or liquidating other assets to fund dividends. While some argue that PIKs can enhance returns, their growing prevalence complicates the assessment of asset quality and the management of cash flows within BDC portfolios.
Although early BDCs were predominantly publicly traded, the past decade has seen a shift in industry composition. Nontraded private BDCs, often managed by large alternative asset managers such as Blackstone [NYSE: BX] and Blue Owl [NYSE: OWL], have grown rapidly, overtaking publicly listed BDCs in total assets. Today, the largest private BDC, Blackstone’s BCRED, manages more than $70bn, highlighting the sector’s evolution to a major channel for private credit investment. This expansion has been supported by increased engagement from the banking sector. Banks have steadily broadened their lending commitments to private credit vehicles, and BDCs have drawn more extensively on these facilities than private debt funds, despite the latter being more than twice their size. By the end of 2024, BDCs had secured approximately $56bn in committed bank credit lines and had drawn around $32bn of this total, leaving an additional $24bn available to them. However, the scale of these commitments is not viewed as systemically significant, particularly because most BDC borrowing is undertaken through bond markets rather than bank credit.
Alongside this growth, regulators have raised questions about the increasing scale and interconnectedness of private credit. The Federal Reserve has observed that limited visibility into private credit exposures complicates assessments of systemic risk, while the Bank for International Settlements has warned that leverage within the sector tends to be “procyclical”, potentially amplifying downturns. Nonetheless, comparative analyses suggest that BDCs are well capitalized. Academics estimate BDCs’ “risk-based capital ratio at 36%”, and even in a “severe adverse scenario” of suffering 16.6% credit losses before revenue, most of them would still be solvent. In this sense, BDCs combine regulated transparency with high income potential while maintaining an underlying structural resilience.
BDCs in the Market
The performance of BDCs is closely linked to prevailing credit conditions. They tend to perform most strongly in periods of economic stability or recovery, when credit spreads are narrow, portfolio companies experience low default rates, and floating-rate loans generate consistent income. In these environments, BDCs commonly deliver annual yields of approximately 11-12%, allowing them to sustain vigorous dividend policies. Their emphasis on floating-rate lending also positions them favorably during cycles of rising interest rates, as higher benchmark rates turn into higher interest income.
Recent years have proven these dynamics, as BDCs benefited from elevated short-term rates during and after the Federal Reserve’s tightening cycle. Investors’ demand for high-yielding assets further reinforced these trends. Analysts estimate that nearly half of new direct-lending inflows were channeled into BDCs rather than broader private credit options. The combined effect of higher yields, reduced bank competition, and sustained investor demand significantly contributed to the sector’s rapid increase in assets under management.
However, BDCs are also exposed to risks that become more pronounced in less favorable market environments. Competition among lenders has increased, exerting downward pressure on loan spreads and encouraging more permissive underwriting structures. When credit spreads widen, BDCs must mark their loan portfolios to fair value, which can lead to declines in net asset values, and, in some cases, sharp discounts in market pricing relative to NAV. During those periods, the use of leverage can amplify the impact of declining asset values. Dividend stability can also come under pressure, as BDCs distribute much of their taxable income, only retaining limited buffers to manage earnings volatility. Should interest income decline or credit losses increase, dividend adjustments may be necessary. This was evident this year, when Blackstone’s BCRED reduced its dividends in anticipation of weaker credit conditions.
Overall, BDCs operate as high-yielding credit vehicles whose valuations and distributions are sensitive to shifts in the market. They benefit from regulated transparency and a structure designed to deliver income, yet their reliance on leverage and exposure to smaller, less liquid borrowers creates certain risks. Consequently, BDCs tend to deliver strong results in periods of stability, yet their valuations and earnings can drastically shift when credit conditions worsen.
First Brands Bankruptcy
First Brands, an auto-parts supplier comprising 24 subsidiaries and funded heavily through leverage of about $12bn, was long known for its aggressive acquisition strategy. But on September 29, 2025, the company filed for Chapter 11 bankruptcy with $12bn in liabilities, following allegations of fraud, double-pledging, and more than $2bn in missing receivables. Its founder, Patrick James, was quickly sued for misconduct as the court approved a $1.1bn DIP loan and launched a $7m independent investigation into the company’s financial irregularities.
The bankruptcy process has triggered a clash among Wall Street lenders in a Houston courtroom. The main battle concerns the terms of the $1.1bn rescue financing and whether the company can keep operating while different creditor groups fight over its remains. At the company’s first in-person court hearing since its filing, First Brands sought final approval for the remaining portion of the $1.1bn loan provided by a group of existing senior lenders. Although the company reached a deal with one crucial creditor group, others, including those tied to inventory-backed lending, have not agreed to terms. If consensus is not reached soon, Judge Christopher Lopez of the US Bankruptcy Court in Houston could impose terms he deems fair.
In exchange for the new $1.1bn in debt, First Brands granted those lenders senior repayment priority on both the rescue financing and $3.3bn of their existing loans. Secured lenders also agreed to share future litigation proceeds more generously with unsecured creditors. Professional fees in the case are expected to reach hundreds of millions of dollars, prompting Judge Lopez to acknowledge that it was an “expensive room” and to encourage all parties to reach a deal after repeated postponements. The committee of unsecured creditors continues to oppose the financing arrangement, arguing in court filings that the loan solely benefits the senior lender group. If the financing is ultimately rejected, the company will be forced into liquidation, making the stakes extraordinarily high.
Alongside the capital structure fight, First Brands has sued its founder and longtime chief executive Patrick James, alleging that he engaged in “fraudulent conduct”. The company claims James and his family misappropriated “hundreds of millions (if not billions) of dollars” to fund a lavish lifestyle, including transferring $8m to his son-in-law’s wellness company, Archive Health, to help cover payroll, with no clarity on whether fair value was received in return. First Brands collapsed into bankruptcy after it became unable to refinance its debt. The company had just $12m in cash upon filing, and court documents revealed $12bn in conventional loans and significant off-balance-sheet financing routed through special purpose vehicles.
The company has told the court it plans to pursue a sale. However, several parties have expressed concerns that senior lenders may move quickly to bid for the company’s assets, making the recovery of the missing cash a lesser priority. The lawsuit against James, who resigned on October 13, stems from an internal investigation launched by the company’s newly appointed CEO and directors. James denies the allegations and supports the appointment of a third-party examiner to review First Brands’ financial practices leading to bankruptcy.
The implosion of First Brands has placed a spotlight on the broader practice of working-capital finance, where companies sell or borrow against accounts receivable or inventory to rapidly raise cash. Lawyers for multiple creditor groups have alleged that First Brands’ downfall was tied to massive fraud, with financial statements misrepresenting key information and the company operating as a “house of cards tainted by financial impropriety and fraud”.
About 80 hedge funds and financial institutions agreed to provide the $1.1bn bankruptcy loan, on the condition that more than $3bn of their existing term loans would receive repayment priority. This has infuriated creditor groups such as Evolution Credit Partners, which argue that the agreement compromises their existing collateral and significantly harms those defrauded before bankruptcy. Evolution has even sought the appointment of an independent bankruptcy trustee for one of First Brands’ affiliates. The financing faces challenges from multiple sides, with creditors arguing that the terms are too rich and give excessive power to the DIP lenders, who also hold more than $5bn in term loans.
As the case continues, First Brands remains one of the highest-profile collapses in recent years, raising profound questions about leverage, off-balance-sheet financing, and the oversight of complex industrial groups. The next rulings in Houston will determine whether the company survives long enough to be sold or whether it will be dismantled entirely.
The impact of First Brands’ collapse and the “Black Box” Problem
The collapse of First Brands sheds new light on the operations of BDCs. Besides prominent names on Wall Street like Jefferies and Millennium, a list of 15 BDCs have been exposed to First Brands through direct investments at the point of its Chapter 11 filing. Even further than the 15 funds that were exposed at the time of Chapter 11 filing, it is documented that over the past 2 years, ahead of its collapse, a total of 20 BDCs have been direct lenders to the company. 5 have exited their positions ahead of the second quarter filings of 2025. In hindsight, these five exits look like an early warning sign. At the time, however, they may have appeared as ordinary portfolio rotation, which underscores how difficult it is to distinguish routine risk-management from informed concern in opaque private loans. It also raises new questions about the valuation of these assets, also referenced as level 3 assets due to their illiquid nature and difficulty in truly valuing. When analyzing the BDCs’ assessments of First Brands’ credit value, one can find stark differences between leading lenders such as Monroe Capital Income Plus Corporation and Prospect Capital. Monroe, for example, marked its first lien debt with a value of $47 million as high as 101% while Prospect Capital valued the same senior instrument at only 92.96%. This stark difference further underscores the challenges of managing level 3 assets. It also leads investors to question the reliability of their investments and money managers. Following the collapse and announcement of this black box of valuations, the market of publicly traded BDCs has undergone a sharp re-rating. Since public reports of involvement by BDCs in the First Brands insolvency, publicly listed BDCs have experienced a significant sell-off by investors, resulting in new pricing. Due to a growing lack of confidence in the investments, the current pricing of these publicly listed BDCs is set at a rough discount of 20% compared to the underlying NAV of the assets held.
BDC Exposure to First Brands:
Additionally, after two Fed cuts in September and October 2025, which brought policy rates down to 3.75–4.00%, markets are now debating whether another cut in December is likely. For BDCs, lower short-term rates compress the income on floating-rate loans and weaken the yield appeal just as sentiment is turning more cautious. This puts further strain on these funds already facing growing investor mistrust. As policy rates fall, BDCs are able to earn less of a yield as they are dependent on the proposed Fed rates. A first announcement by the leading player in space, BCRED, a flagship private BDC managed by Blackstone, to cut monthly distribution from $0.22 to $0.20 per share further hurts the current market sentiment of the space. As the retail investors and larger institutions are already growing skeptical of the investments and potential yield, a lower return further fuels a lower appetite for the segment.
The revelation that a company of First Brands’ scale could allegedly hide billions in off-balance-sheet vehicles and missing receivables has forced investors to question the accuracy of Net Asset Values (NAVs) across the sector. If audited borrowers can obscure this level of leverage, the premium investors demand to hold BDC equity will likely rise to account for this opacity risk.
Conclusion
The First Brands story serves as an eye-opener for the rapid democratization of private credit and specifically the rise of privately held Business Development Company funds. It doesn’t mark the end of the BDC boom, with risk-based capital ratios averaging 36%, the sector remains structurally resilient against systemic collapse. As credit cycles normalize, we are likely to see a split in the industry. Large managers with the resources to conduct forensic underwriting and navigate complex bankruptcies will likely consolidate their dominance, as further seen in the example of First Brands. Leading players with careful analysis and available resources were able to remove themselves from the failing situation. The other side of the market could be made up of smaller BDCs that chase yield into “hairier” credits. These smaller firms may face a reckoning of non-accruals and NAV write-downs, but will also cut out a niche in the market for the investor going after that high yield.
Ultimately, BDCs have succeeded in their mission to channel capital to the middle market, filling a void left by retreating banks. However, the investor also needs to acknowledge that the double-digit yields offered by these vehicles are not a guarantee. Instead, they are the market’s price for bearing the risks of complexity, illiquidity, and the occasional, but potentially devastating, failure of governance. Rather than ending the current form of private credit, analysis suggests that First Brands will likely push investors and regulators to re-price opacity risk, widen NAV discounts, and reward those platforms that can prove their underwriting and valuation discipline.
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