AI-Driven Anxiety in Software Stocks Is Wreaking Havoc on Private Markets
For more than three years, artificial intelligence (AI) and the investments tied to it have been framed as a once-in-a-generation opportunity to create wealth. It has been touted as a technological breakthrough that is so powerful that it can justify almost any level of spending by the hyperscalers who work at breakneck speeds to build the compute capacity needed to support future growth and demand.
But recently, investors have grown more skeptical about how quickly AI investments will translate into tangible profits, and the market is beginning to look past the glossy narratives and focus instead on each company’s balance sheet. In that shift, some of the weakest links are not the companies developing the technology themselves, but rather the lenders who are financing their growth.
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Few corners of the market illustrate this better than business development companies (BDCs) and private credit funds. These vehicles, which are often marketed as high-income solutions in a world where yields are harder to come by, are suddenly under pressure as fears around slowing AI-related revenues ripple through their loan books.
The current period of investor angst around AI is often framed as a question of valuations and whether the biggest technology companies can grow fast enough to justify the money being spent to develop data centers and the chips that power them. Tech investors are increasingly worried that AI will automate many of the repeatable tasks that have historically supported annual recurring revenue growth across software and service companies.
If that proves true, the concern encompasses slower growth as well as pressure on pricing and margins. Even for large, diversified players like Microsoft, Salesforce, or ServiceNow, the market is asking harder questions about whether their business models are defensible against the threat of AI.
If those questions are being asked of profitable, cash-rich, public companies, the implications for smaller, less profitable firms are far more severe. Many of these companies do not have access to public markets or large cash buffers. Instead, they rely on private credit managers for growth capital.
One of the most underappreciated risks in private credit today is the growing reliance on payment-in-kind (PIK) loans, and the recent selloff in publicly traded software stocks is bringing that risk into sharper focus. These structures allow borrowers to defer making interest payments by adding them to the principal loan balance instead, which is believed to ease short-term liquidity pressures.
But as valuations for public software companies compress and investors question the durability of the AI growth story at large, the optics around PIK have changed. What once looked like financial flexibility now increasingly reads as an early warning sign that a borrower won’t be able to service debt obligations with future cash flows as initially intended.
Following the global financial crisis, SS banks pulled back from lending to smaller and mid-sized companies. Private funds stepped in, offering flexible capital in exchange for higher interest rates and tighter covenants. And for investors starved for income, the appeal was obvious, as it’s not uncommon for BDCs to advertise dividend yields that are two, three, or even four times higher than the average dividend yield of the constituent companies that make up the S&P 500 Index.
But the recent drawdown in the sector is a reminder that high yields are rarely free, and that when higher income is the primary selling point, investors often underestimate the fragility underneath. To be fair, this dynamic is not unique to private credit or BDCs. It closely mirrors what we have seen historically in the riskiest corners of the commercial real estate market, where the highest yielding REITs tend to be offered by companies that own the most vulnerable or economically challenged properties.
In real estate, elevated dividend yields are often a function of tenant risk and lower asset quality. For instance, REITs concentrated in secondary office markets, aging retail centers, or highly leveraged hospitality portfolios have frequently dangled double-digit yields to attract capital.
Those payouts may look compelling on the surface, but they are often supported by tenants with weaker balance sheets, shorter lease durations, and revenues that are far more vulnerable to economic slowdowns. And when occupancy rates dip or refinancing costs rise, the dividend is often the first casualty.
Private credit and BDCs operate under a similar logic. The reason they can offer yields that far exceed those of traditional dividend-paying equities is because the companies they lend to are inherently riskier.
As fears around AI continue to reshape expectations for the technology sector, the stress emerging in private credit is a reminder that fundamentals still matter. The market may tolerate ambitious narratives for a time, but eventually it demands proof. When that proof is delayed, the highest-yielding corners are often the first to feel the pain.
For investors, the takeaway is straightforward but uncomfortable: income is never just income; it is compensation for risk. And when yields look too generous, the risk is usually closer than it appears.
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Malcolm Ethridge is the Managing Partner at Capital Area Planning Group, based in Washington, D.C. His areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits.
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