We are sometimes asked whether financial professionals should be worried about the amount of payment-in-kind (“PIK”) debt being used in private credit portfolios. Our answer is “it depends,” and there is a second clarifier that is important to explain: “Which kind of PIK?”
What is PIK?
Instead of paying interest payments in cash, as is typical, the borrower may pay a portion of the interest payment in the form of more debt, typically at a higher interest rate, and in a senior priority position to the equity. As a result, the total amount of debt grows.
We generally view PIK in two buckets:
“PIK at Origination” is offered at the beginning of the loan term as an option and typically to fast-growing companies that are viewed as higher-quality borrowers. This option can allow the borrower to reinvest more cash back into future growth, particularly during periods of expansion. These arrangements can also occur during the life of the loan to support investment into new growth initiatives.
- Typically offered for a finite period—for example, the first two years of the loan term—and will increase the interest rate if exercised.
- Typically offered by the lender at origination as a sweetener to a higher-quality borrower.
- Typically, only a small portion of the interest rate is allowed to “PIK” while the base rate and a portion of the credit spread is still paid in cash.
- Viewed by the lender as low risk and may even be an indication of higher-quality borrowers.
- Referred to in industry jargon as “PIK toggle” since it can toggle on and off at the borrower’s discretion.
“PIK after Origination” or “Amendment PIK” is often offered as the result of a company struggling to make its agreed-upon payments. PIK debt may then be offered by the lender, often in conjunction with additional equity contributions by the sponsor, as a way to extend some runway or grace, with the view that the borrower can improve its financial position in time and make good on its backlog of interest owed.
- Offered only to existing borrowers and not at origination of the loan.
- Typically viewed as higher risk and can be an indication of stress in a loan portfolio. The lender often requires extra collateral in case the company's ability to service the debt doesn't materialize.
- This support of companies was used extensively during the COVID crisis, and we believe it improved outcomes for both the underlying companies and private credit investors.
- This type of support is not available to publicly traded loans/bonds where bankruptcy is typically the only restructuring option.
- The type of private debt fund holding the loan can be relevant, as senior secured direct lending may employ less PIK since investors desire cash payments, while PIK may be more prevalent in junior financing, distressed debt, and special situation funds, where the lender helps the borrower execute a turnaround strategy.
In our view, PIK is misunderstood and is a tool that direct lenders can use to garner outsized returns by providing it selectively to higher-quality borrowers. When inquiring about various managers’ approach to PIK, it’s important to distinguish whether the PIK income is provided at origination to support growth or if the PIK is providing flexibility to an underperforming credit.
