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Utilization of Payment-in-Kind Provisions in Private Credit

Highlights

  • Recent media reports have highlighted the risks of increased utilization of PIK loans by private credit funds.

  • According to Fitch Ratings, utilization of PIK surged in 2020 as companies sought to preserve liquidity in the midst of the COVID-19 pandemic and growing competition from the broadly syndicated loan market has played a part in the rise of PIK terms in loan agreements.

  • On average across all non-traded BDCs currently covered on the Altidar platform, reported PIK income as a percentage of total investment income has increased from 5.9% in 2023 to 6.2% for the first half of 2024.


Private credit funds often hold investments in which all or a portion of the interest or dividend payment is in the form of the issuance of additional securities, known as payment-in-kind (“PIK”) interest or dividend. PIK provisions may be included in loan documents at origination, known as PIK at origination, or when a distressed borrower needs relief, known as PIK by amendment. Deferring cash interest payments for a period of time can help to temporarily alleviate borrower liquidity challenges; however, it reduces cash flow to the lender and the increased loan balance can make it more difficult for the borrower to refinance or repay the debt when it matures.


On August 6, 2024, Bloomberg reported that Prospect Capital Corporation (“PSEC”), a listed business development company (“BDC”) that is conducting a continuous offering of non-listed preferred stock, has attracted significant criticism recently from various analysts, and in particular, for potential risks posed by the fund’s utilization of PIK loans, which represented approximately one-third of its net investment income for 2023. The percentage of PSEC’s investments with the potential of PIK income was 31.3% as of June 30, 2024, up from 27.3% one year earlier. In a statement posted on its website, PSEC defended its use of such arrangements, stating “Prospect’s payment-in-kind interest can be an efficient funding mechanism for certain portfolio companies where such companies are making accretive investments in their business with valuations substantially above Prospect’s cost basis.”


PSEC is not alone in its increased utilization of PIK terms. Fitch Ratings notes that growing competition from the broadly syndicated loan market has played a part in the rise of PIK terms in loan agreements, which are increasingly being used as private lenders compete for transactions. Utilization of PIK surged in 2020 as companies sought to preserve liquidity in the midst of the COVID-19 pandemic, a trend that has continued in subsequent years. According to Bloomberg, PIK fell out of favor during the years following the global financial crisis due to the lower costs and wide availability of debt; however, the higher rate environment has played a role in driving this trend, as the elevated interest rates have left a growing number of companies struggling to accumulate interest paid-in-kind in lieu of cash payments. The graph below presents PIK income: (i) as a percentage of total interest and dividend income, based on a survey of BDCs rated by Fitch; and (ii) as a percentage of total investment income for all non-traded BDCs currently covered on the Altidar platform:

BDC PIK income as % of income

NOTE: In certain instances, we have included figures reported in a fund’s statement of cash flows when PIK income is not reported in the statement of operations or the accompanying notes. Amounts reported in the statement of cash flow may not be consistent with amounts that would have been included in the statement of operations if required.

According to a survey conducted by Bloomberg, references to PIK in company filings and presentations have doubled since the onset of the COVID-19 pandemic; among BDCs over the past half-decade, the number of mentions rose about 240%. The average percentage of portfolio investments that have the potential for PIK income was 11.8% as of June 30, 2024 for all non-traded BDCs covered on Altidar, an increase from 11.3% one year prior. Additionally, the average percentage for potential PIK income was 14.8% on a weighted basis as of June 30, 2024, an increase of 130 basis points from one year earlier. The graph below illustrates the percentage of the portfolio (by fair value) that has the potential of PIK income as of June 30, 2024 and June 30, 2023 for all non-traded BDCs covered on Altidar:

BDC potential PIK

The graph below illustrates reported PIK income as a percentage of total investment income for the six months ended June 30, 2024 and the year ended December 31, 2023; the average percentage has increased from 5.9% in 2023 to 6.2% for the first half of 2024:

BDC PIK %

(1) We have included figures reported in the fund’s statement of cash flows when PIK income is not reported in the statement of operations or the accompanying notes. Amounts reported in the statement of cash flow may not be consistent with amounts that would have been included in the statement of operations if required.

 

Sources

 

Disclaimer: The information contained in this research note has been assembled using publicly available information. While SK Research and Due Diligence, LLC (“SKRADD”) believes it to be reliable, there is no guarantee that all of the information contained in this research note is or will be accurate. This research note does not constitute investment advice and is intended for informational purposes only. This research note does not constitute an offer to sell or the solicitation of an offer to purchase, nor should it be considered a recommendation of any security referenced herein. This publication is copyrighted, and no person is authorized to make use of the information presented herein without the express written permission of SKRADD. SKRADD is under common ownership and control with Snyder Kearney, LLC, a law firm that conducts due diligence reviews of alternative investment programs, including non-traded real estate investment trusts.

 

©2024 SK Research and Due Diligence, LLC.

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