BDCs Reliant on Spillover Income to Support Dividends in Declining NII Environment; Negative Cash Flow Could Result in Changing Capital Strategies Should BDCs Maintain Current Dividend 

• Many public business development companies do not generate enough free cash flow from their current investment portfolio to fund dividends and are instead relying on investment sales or capital market activity.
• Octus analyzed 12 BDCs that mentioned spillover income in their third-quarter 2025 calls. All but one of the BDCs reported net income below reported dividends. However, many of the BDCs analyzed generated cash from investment portfolio that was not sufficient to cover cash dividends.
• In the case where dividends exceed BDC-reported net income, companies are reliant on spillover income, undistributed prior earnings, to support declared dividends. Certain BDCs have built spillover reserves covering three quarters’ worth of dividends.
• BDCs have differing ways of thinking about spillover income. A number of BDCs use spillover income as a cushion for dividends if income declines. Other BDCs plan their dividend strategy based on current spillover income, incorporating the use in future dividend plans. Sixth Street Specialty Lending appears to be against the practice of using spillover income to build a dividend strategy around calling the use of spillover income a return OF assets and not a return ON assets.

In part due to rising interest rates and perhaps certain portfolio underperformance, a number of companies are having to rely on payment-in-kind interest to defer cash payments to avoid default. A number of BDCs analyzed by Octus generate insufficient cash from investments to fund cash dividends.

Separately, a number of BDCs do not generate enough net income to cover dividends, even when including PIK income.

In order to continue supporting dividends at previous rates, BDCs can rely on spillover income, which is accumulated taxable income that a BDC earned in a prior fiscal year but did not distribute to shareholders. This rule comes from the BDC’s status as a regulated investment company, or RIC, under the U.S tax code. In order to avoid corporate taxation, a RIC must distribute 90% of its taxable income. It does not, however, have to pay out 100% of that taxable income in the year it was earned. If a BDC’s taxable income exceeds its distributions, the excess is carried over into the following year. The BDC then has four subsequent years to distribute that carried-over income before incurring tax on it.

BDC earnings from their portfolio loans that is net investment income, or NII, can be volatile due to factors such as:

• PIK income: This is the most significant source of liquidity mismatch. PIK interest is interest that is accrued and taxable but not paid in cash; instead, it is added to the loan’s principal. Since the BDC’s taxable income, or TI, includes this noncash PIK component, the BDC is legally forced to pay a cash dividend to shareholders based on income it has not yet received. This forces BDC management to rely on cash from the spillover reserve to cover the payout.
• Fee income: Origination fees are immediately taxable, but quarterly NII only recognizes the yield.
• Credit events: Loan defaults or nonaccruals can reduce current NII.

During periods of stress driven by rising borrowing costs or nonaccruals, a BDC’s current quarterly NII will fall below its dividend. When this happens, BDC management must rely on spillover income to avoid cutting the dividend. The liquidity mismatch from noncash PIK income is a primary factor during times of financial stress because management is forced to draw cash from its balance sheet and deduct the amount from the accumulated spillover reserve.

A BDC business reporting flat interest income may seem stable but that stability masks an underlying deterioration in core lending margins that must be maintained by fee income or PIK revenue sources. If the BDC is reporting lower cash NII, this is showing its reliance on PIK and the acceleration of fees indicates that the BDC’s core repeatable cash generation is shrinking.

This article examines 13 BDCs that disclosed during their third-quarter calls having meaningful spillover income.

Free cash flow after dividends is shown in the chart below, representing the net cash surplus or deficit remaining after the quarterly distribution is paid.

Comments from a number of the BDCs analyzed from third-quarter calls are reviewed below. There appears to be a difference in thought on using spillover income. A number of BDCs talk about spillover income representing a cushion for dividends if income declines. Many BDCs plan their dividend strategy incorporating the current level of spillover income in future plans. Sixth Street Specialty Lending appears to be against the practice of using spillover income to build a dividend strategy around calling the use of spillover income a return of assets and not a return on assets.

• Bain Capital Specialty Finance: “We’ve been operating with meaningful net investment income dividend coverage, which has provided excess income that has been distributed to our shareholders via supplemental dividends and also increased retained earnings, driving healthy spillover income equal to $1.46 per share or 3 times our regular dividend level,” adding “that if net investment income comes down,” the company would have “levers” to keep NII higher, but “we do have decent cushion from a spillover income perspective.”
• Barings BDC: “We currently have spillover income of $0.65 per share, which equates to more than two quarters of our regular dividend, reflecting the continued strength of our earnings and portfolio performance. Taken together, the durability of our earnings and the meaningful spillover provides a solid foundation as we move into 2026.”
• Blue Owl Capital Corp.: “As we have previously reported, our spillover income remains healthy at approximately $0.31 per share and supported our base dividend this quarter.”
• Carlyle Secured Lending: “In addition, we currently estimate we had $0.86 per share of spillover income generated over the last five years to support the quarterly dividend, which represents more than two quarters of the existing $0.40 quarterly dividend.”
• Sixth Street Specialty Lending: “We believe there is a misconception that spillover income protects the dividend. However, using spillover to cover the dividend simply reduces net asset value. This is a return of capital, not a return on capital and ultimately diminishes shareholder value if earnings don’t support the payout.”
• Horizon Technology Finance Corp.: “Every quarter we discuss the distribution and take into account the current income rate level and the future level of the Horizon platform and look at the spillover. And we’ll determine the amount of distribution on a quarterly basis.”
• Ares Capital Corp.: “We believe this level of spillover income gives further visibility to our investors, since it provides a cushion to support our quarterly dividends in the event of temporary shortfalls in our quarterly earnings.”
• PennantPark Investment: “PNNT has $48 million, or $0.73 per share, of undistributed spillover income, and we plan to use the spillover income to cover shortfalls in net investment income versus the dividend at this time.”

Based on the above analysis, the majority of BDCs in this sample did not cover their dividends with operating cash flow in the third quarter. However, all but one covered their dividends on a reported net income basis.

As shown above, Octus’ approach looks at cash flow and compares with dividends being paid. Reported net income is used by companies to determine dividend payouts, but it is important to see how those dividends are being funded, and as stated above, many of the BDCs in our sample had cash flow that was lower than cash dividends during the quarter.

Alternatively, as in the case of Bain Capital and Hercules, cash flow was masked by new investments. Backing out net cash flow from new investments, Bain Capital generated $31 million in core cash covering its $29 million dividend, and Hercules generated $105 million covering its $84 million dividend. In other words, management is using the balance sheet to grow the asset base, but the core dividend is fully covered by operations.

However, many of the BDCs are operating with cash flow that does not cover their cash dividend.

It is unclear what companies will do if they have repeated cash flow deficits. Octus provides a framework for looking at certain BDCs by combining cash flows with spillover income coverage tests.

• Bain Capital has both positive cash flow and a 3.24x spillover cushion as a multiple of quarterly dividends.
• Barings BDC’s core earnings are lower than its reported dividend, but it also maintains a relatively high spillover buffer of 2.1x.
• Blue Owl Capital Corp. operates with a cash flow deficit from core investment income of negative $62 million in the third quarter, and it also has spillover income of under 1x (0.84x).

Spillover income for those 12 BDCs is listed in the table below and compared with reported third-quarter dividends:

A continuous NII shortfall forcing the use of spillover could point to worsening credit quality in the loan portfolio:

• Elevated PIK: An accelerating reliance on PIK income (noncash interest) forces the BDC to draw on the reserve to meet its tax-mandated cash dividend. This suggests that a growing number of borrowers are under financial stress and cannot pay cash interest.
• Nonaccrual pressure: If the shortfall is due to an uptick in nonaccrual loans (defaults), the continuous drawdown is a financial representation of realized credit losses, which is a fundamental threat to the BDC’s health.

While spillover drawdown itself is a tax accounting event, the underlying cause paying a dividend that is not covered by true earnings could result in liquidity shortfalls or a mismatch in capital allocation:

• Asset bleed: When a BDC pays out more than it earns, the difference is funded by liquidating assets, borrowing, or issuing new equity. The value of the assets backing the dividend is effectively shrinking.
• NAV decline: A sustained drawdown is typically associated with a decline in the BDC’s net asset value, or NAV, per share. Since a BDC’s share price tends to track its NAV over the long run, this erosion leads to a permanent loss of investor capital.

As noted above, BDCs can support dividends by reducing investments or winding down portfolios to cover cash shortfalls. They can also rely on existing liquidity, which is shown in the table below with liquidity in millions of dollars: