OFS Capital's Dividend Sustainability Crisis and Its Implications for Investors

The recent 50% dividend cut by OFS Capital Corporation, announced in October 2025, has cast a stark light on the fragility of dividend sustainability in the business development company (BDC) sector. This move, which reduced the quarterly payout from $0.34 to $0.17 per share, reflects not only the company's deteriorating financial health but also broader systemic challenges facing BDCs in a high-interest-rate environment. For investors, the episode underscores the risks of relying on high-yield dividends that may be propped up by unsustainable practices such as the use of spillover income.

OFS Capital's financial performance in Q3 2025 reveals a company struggling to align its dividend policy with its earnings capacity. The firm reported a net investment income of $0.22 per share for the quarter, a decline from the previous quarter, while simultaneously recording a net loss per share of $0.62 due to significant unrealized depreciation on its investment portfolio. The company's net asset value (NAV) per share fell from $10.91 to $10.17 during the same period, driven by markdowns on equity investments, including its position in Pfanstiehl Holdings, Inc., and CLO equity holdings according to DCF modeling. With only $5.0 million in cash and cash equivalents (including $2.5 million in restricted funds) as of September 30, 2025, OFS Capital's liquidity position appears precarious according to Webull analysis.

OFS Capital's dividend coverage ratio, inferred from quarterly data, appears to be in a similar precarious position. Assuming an annual NII of $0.88 per share (based on Q3's $0.22 per share) and total dividend payments of $0.68 per share (based on the Q4 cut of $0.17 per share), the company's coverage ratio would be approximately 1.3:1. This suggests that OFS Capital is already relying on spillover reserves to fund its dividend, a strategy that may not be viable indefinitely according to BDC Reporter analysis.

The sector-wide reliance on such reserves is evident: Barings BDC, for example, reported spillover income of $0.65 per share, sufficient to cover more than two quarters of its regular dividend. However, as KBRA's analysis highlights, declining NII due to factors like lower base rates and increased non-accruals could force further dividend reductions for BDCs with limited spillover buffers.

For investors, the implications are clear. High-yield BDCs, particularly those trading at significant discounts to NAV, often mask underlying risks. OFS Capital's 50% dividend cut is a cautionary tale: while the company's shares may appear attractive at a 10% discount to NAV, the erosion of its NAV and liquidity reserves suggests that the dividend yield is not supported by sustainable earnings. This aligns with broader sector trends, where firms like Prospect Capital Corp and Blue Owl Capital have also faced scrutiny for their reliance on spillover income.

The use of payment-in-kind (PIK) interest further complicates the picture. PIK interest, which is noncash income added to loan principal, forces BDCs to issue dividends based on income they have not yet received. This liquidity mismatch often compels firms to draw from spillover reserves, exacerbating the erosion of NAV. OFS Capital's portfolio, with a weighted-average performing income yield of 13.6% in Q2 2025, may appear robust, but the extent to which this yield includes PIK interest remains unclear.

In conclusion, OFS Capital's dividend sustainability crisis is emblematic of a sector grappling with the dual pressures of declining earnings and rising liquidity demands. For investors, the lesson is to scrutinize not just the yield but also the quality of the underlying earnings and the extent of spillover income reliance. As Fitch warns, the deteriorating environment for BDCs in 2025-marked by leverage, non-accruals, and economic headwinds-suggests that further dividend cuts may be inevitable. In such a climate, prudence, rather than yield-chasing, should guide investment decisions.