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LPs monitor private credit managers as PIK use rises
by Lisa Fu
As the use of payment-in-kind in direct lending increases, LPs are worried that the tool is being co-opted by the wrong strategies and offered to low-quality borrowers.
Use of PIK in low risk, low returning private credit strategies like senior secured lending is more concerning than its use in a high return-seeking strategy like structured solutions, said Chris Shelby, private markets managing director at Verus. He has seen PIK use in senior secured direct lending increase as companies struggle.
Sponsor-backed companies using PIK for senior debt now account for 12% of the KBRA DLD Direct Lending Index, the highest since the index began tracking PIKs in 4Q 2023, according to an October report from the ratings agency.
“The concern is that these are supposed to be cash-pay base-rates plus a spread,” Shelby said. “If that strategy goes from 100% cash pay or potentially a majority and you PIK, that means you’re not being de-risked the same way.” Some investors rely on cashflow from lower returning strategies to fill a specific portfolio allocation or reinvest in other securities.
Consultant WTW has also noticed an uptick in PIK and PIK toggles in direct lending funds, and is monitoring them to ensure sufficient debt service coverage ratios, said Karin Anderson, director in credit manager research.
We expect PIK to occur with companies that don’t have the cashflow
Karin Anderson
Director in credit manager research
WTW
“The bottom line is we expect PIK to occur with certain types of companies that don’t have the cashflow,” Anderson said. “In places where we weren’t expecting it, we would want to monitor to understand the rationale and how the lender is being compensated for the higher risk relative to cash-pay interest.”
Differentiating between great credits and below average credits when structuring a deal and including PIK consideration, is the biggest issue, said Dave Scudellari, global head of private assets and strategic partnerships at AIMCo. The rise in PIK use is a natural response to the 500bps run in interest rates, but PIK should only be offered to high-quality borrowers, and with better documentation.
“If PIK makes sense for a solution, we’re fine with that,” he said. “We are long-term capital, so we don’t need the current coupon in the portfolio. What we need is an absolute conviction that we’re going to get paid.”
Others say PIK use is concentrated in certain areas, such as the upper end of the market. It is unlikely to be widespread in the core and lower middle market, according to Francis Griffin, senior vice president in Callan’s alternative consulting group. Similarly, PIK use is probably more common in sectors such as tech or healthcare or financials, where a lot of deals can be done as recurring revenue loans.
“I don’t think there’s a significant amount of worry across the broader private credit universe,” Griffin said.
