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A growing list of cash-strapped companies have turned to their lenders at private credit funds for relief in recent months, seeking to conserve capital by delaying payments on their debt.
The rate at which companies are opting to increase their principal balance instead of paying cash, known as “payment-in-kind” or PIK, edged higher during the second quarter, according to a recent report from rating agency Moody’s. These types of loans have a catch: while they provide temporary relief, they often come with a higher interest rate on a mounting debt load as the deferred payments pile up.
The publicly traded private credit funds that the rating agency keeps tabs on reported the highest levels of PIK income since it began tracking the data in 2020 — though the income is paper profit and it is not clear how much of the gains will actually be realised.
The growth in these types of loans is one signal of stress in corporate America even as the broader economy expands, particularly for businesses that were leveraged to the hilt by their private equity owners and are now struggling with those interest burdens.
“PIK was born out of necessity and is something that people in the market viewed as a temporary situation,” said Sheel Patel, a partner at King & Spalding, referring to recent high interest rates. “Even though the interest rate environment has changed, I think that sponsors will continue . . . trying to keep it in their documents.”
While the Federal Reserve’s move to cut interest rates in September is the first step in alleviating pressure on borrowers, rates are expected to remain far higher than the rock-bottom level they hit in the immediate aftermath of the Covid-19 pandemic, when private equity firms went on a debt-fuelled buyout binge.
Companies could afford the interest burden then. But as rates surged above 5 per cent, interest costs for many highly levered businesses began to eat up most of their cash. That financial distress is showing up, in part, through the swell of PIK income reported by credit funds, fuelling worries that some borrowers are wrestling to stay afloat.
The shift to PIK borrowing is just one risk being borne by the burgeoning private credit industry, where asset managers lend directly to businesses. The loans — while risky — can generate lucrative returns to the lenders who are willing to provide the capital.
Moody’s estimated that 7.4 per cent of the income reported by private credit funds was in the form of PIK during the most recent quarter. Analysts at Bank of America pegged the figure at 9 per cent and said its analysis showed that these funds had gone one step further: 17 per cent of the loans they hold give the borrower an option to pay at least part of their interest with more debt going forward, even if they are not doing so now.
In the second quarter, Blue Owl’s technology fund reported that 23.6 per cent of the income it was earning was in the form of PIK. It was followed closely by Prospect Capital at 18.6 per cent, New Mountain Finance at 17.7 per cent and Ares Management’s ARCC — one of the largest of the funds — at 15.4 per cent.
Prospect did not respond to a request for comment. New Mountain declined to comment.
Beauty Industry Group, a maker of hair extensions backed by private equity group L Catterton, was among the companies seeking to reduce its cash interest burden this year. Its lender, Blue Owl, agreed to take roughly a fifth of its interest payments in PIK. In exchange for the option, the company’s overall interest bill went up.
The same was true for Avalign Technologies, which sought flexibility from Ares this year. The manufacturer of medical implants amended its loan so that, while it would pay more over time, it could put off roughly 30 per cent of its interest payments.
While PIK income is counted as income each quarter, the funds do not receive cash payments until the loan is refinanced or matures. That can create a liquidity crunch for funds, which are required to pay out 90 per cent of their income to investors, even when they have not received cash on those debts.
The uptick in PIK income itself can make investment income at these funds look more attractive, even though the companies bearing the debts are struggling — and the funds are not yet getting paid in full.
PIK is not always a worrying sign, said Clay Montgomery, a Moody’s analyst. Some funds offer PIK to allow healthy businesses to direct their cash towards expansion plans. But it can be difficult for investors to discern when PIK is being extended to give a lifeline during a time of financial stress, or ambition.
For investors, understanding the difference is crucial. Lenders said that if built into a loan at the start, PIK did not indicate stress. Ares said that more than 90 per cent of second quarter PIK income at one of its funds was structured at the start of the investment. Blue Owl said more than 90 per cent of the loans in its technology fund that can defer payment were structured that way from the start.
Because PIK income compounds at a higher rate than cash interest payments, it can be a boon to lenders. But by the same token, once it starts rising, it can become too onerous for some companies to pay back. It can also be used as a tool to avoid impairing debt until a later date, with some investors worried it allows companies to kick the can on what will still end with a default and resulting loss.
Khoros, a software company owned by Vista Equity Partners, is one such company that struggled to repay its PIK interest bill as its business deteriorated. Earlier this year it began to defer the entirety of its debt payments — at an interest rate of more than 16 per cent — and several lenders marked it as a troubled loan.
Vista and L Catterton declined to comment. Linden Capital Partners, the owner of Avalign, did not respond to a request for comment.
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