BDCs shrink their books by choice as redemptions bite

Morningstar DBRS has put a number on the defensive quarter in BDC land: average non-accruals across its coverage universe reached 3.4 percent of investment portfolios in the second quarter of 2026, up from 3.1 percent in the fourth quarter of 2025. The rating agency calls the move manageable, but it arrives while BDCs, squeezed by redemptions, are choosing to make their books smaller.

Morningstar DBRS says many BDCs have responded to increased redemptions over the past two quarters, mostly from retail investors, by letting repayments and portfolio exits outpace new originations. That slows portfolio growth and, in some cases, produces modest contraction; the trade-off, as the agency frames it, is liquidity preserved and leverage kept within manageable levels.

Anthony Tran, assistant vice president in Morningstar DBRS's global non-bank financial institutions group, summarized the logic: "In response to a more challenging operating environment, many BDCs have taken a more defensive approach." The fuller logic is that preserving liquidity, maintaining leverage, and improving portfolio resiliency matter more than the growth they forgo.

BlackRock TCP Capital Corp is the most visible practitioner, having sold 48 percent of its debt holdings to secondaries investor Pantheon after earlier using CLO equity sales as a liquidity valve. The open question on what remains comes down to pricing a shrunken book. It is a concrete instance of the direct-lending reset this publication has described: when origination volume sags, asset sales become the deployment.

The rating agency frames the contraction as a choice rather than a consequence: BDCs are repositioning portfolios and cutting exposure to challenged borrowers, which is why credit performance has weakened only modestly. A three-tenths-of-a-point rise in non-accruals over two quarters is not a credit event. The agency does not anticipate a material acceleration that would pressure ratings across its coverage universe unless the broader economy deteriorates enough to hurt company performance.

The software-sector scare has not shown up in the data: Morningstar DBRS said software exposure did not meaningfully contribute to the rise in non-accruals across its coverage universe. Software investments averaged about 15.7 percent of BDC portfolios at fair value in the second quarter, well below the roughly 25 percent industry average, a gap that suggests BDC managers had already trimmed the sector before the current quarter.

The behavior is right for a sector under redemption pressure, and it deserves a sharper description than 'defensive.' These managers are re-underwriting the books they already hold, selling what they do not want to carry and letting repayments do the rest. The direct-lending slowdown is not over, and asset sales and portfolio exits are the new deployment.

The trade-off sits in the forward economics: a shrinking portfolio earns less fee income, and a BDC that keeps leverage low will lag in any rally, but it will also be the one with capital to deploy when the market turns. Third-quarter non-accruals and whether portfolio exits keep outpacing originations are the next test; sustained through year-end, the defensive posture becomes the strategy.