A useful tool, or hidden default? Take your PIK

There was a time when a company seeking a payment-in-kind option was a surefire sign of trouble. Think of the credit bubble that led to the global financial crisis. After all, PIK loans allow a borrower to pay some part of the interest not with cash, but by adding more debt into the principal to be paid later – a risky proposition, particularly in times of economic stress.  

Whether PIK features still signal distress depends on who is negotiating them and when, where they sit in the capital structure and whether they are mandatory or being paid at the borrower’s discretion.  

“The circumstances matter a lot,” says Matthew Freund, managing director at Barings. Some first-lien lenders may achieve enhanced yield in a sponsor-backed company where “everybody acknowledges the enterprise value of the company more than collateralises the debt balance”. But for junior capital, if things are not going well and the cash rate is converted to PIK, albeit at a higher rate, “in many instances that’s a signal of distress”. 

One thing is clear. The use of PIK features is on the rise, and in rated companies is often identified as a default. Given the limited disclosure in private funds, investors may be unaware that a manager is employing PIK until a company defaults.  

Corporate defaults are surging, with Moody’s Investors Service noting in a late July report that these jumped 30 percent in the second quarter on Q1, and that private equity-backed distressed exchanges, which included the PIKing of cash interest, dominated other forms of defaults. Distressed leveraged buyouts accounted for two-thirds of the 27 corporate family defaults in the quarter, with the two largest completed by sponsored companies, with a total of nearly $5 billion in defaulted debt.  

Moreover, Moody’s is forecasting that the default rate, which stood at 3.8 percent at the end of June, will peak at 5.8 percent in the first quarter of 2024, amid slowing growth, higher interest rates and leverage-heavy companies. S&P Global Market Intelligence is reporting that bankruptcy filings among private equity portfolios are on track to reach their highest annual level since 2010. 

US corporate bankruptcies overall rose in July – with the latest filings pushing the tally so far this year past the total for 2022, per S&P Global.  

Still, some managers are employing PIK options in growing companies.  

“Historically, PIK would have been viewed as a red flag,” says Jason Strife, who leads Churchill’s private equity and junior capital platform. But in the current high interest rate environment, it is being used for performing businesses owned by blue-chip managers as a “capital structure management tool”.  

Churchill’s co-head of senior lending, Randy Schwimmer, distinguishes between PIK’s use by direct lenders, where it can “give a company a cushion against higher rates”, and the liquid market where, absent financial covenants, a company goes right into default, leaving “50 different lenders fighting for position” and looking for strategies to get out.  

Positioning matters

The position in the capital structure matters. Some say PIK options are extremely rare for senior loans, although they are increasingly being used for performing businesses facing a doubling of interest expense because of the Fed’s steep rate increases. Some lenders are offering PIK features on senior debt to provide higher leverage on deals, with an additional yield on the PIK portion to compensate for the risk.  

But James Vanek, a partner and co-head of global performing credit at Apollo, says that “investors should be wary of the argument that you’re getting more in returns, because that assumes you will be repaid in full by borrowers who are often facing cashflow pressures”. 

Vanek notes that agreeing to PIK a portion of the debt up-front, when structuring a deal, can support a company’s ability to grow, but granting a PIK amendment after the fact is usually a sign of underperformance or cash-flow constraints.  

“If somebody’s got distress in a portfolio and wants to avoid reporting a default, they may change the structure to allow for PIK,” says Chris Flynn, president of First Eagle Alternative Credit. “Nobody’s doing this unless they absolutely have to,” he adds. “With that said, in the spirit of transparency and credibility, that investment should be reported as a default, in my opinion,” he adds.  

PIK amendments come with a cost. “The only way a lender is going to do a [PIK] amendment is if the sponsor is on board” and is willing to contribute more equity, says Meghan Neenan, a managing director at Fitch. “They’re going to get their pound of flesh.” 

Although partial PIK toggles may be useful if a company is having a short-term credit crunch, “as a lender you never want to flip into a PIK loan or provide a PIK toggle where you’re in serious distress,” says Gregg Bateman, a partner in the global bank and institutional finance and restructuring group at Seward & Kissel. “It’s not a good prospect for a lender to kick the can down the road.” 

Indeed, the public markets are rife with examples of PIK deals gone awry. In the summer of 2022, a group of lenders led by Deutsche Bank and UBS suffered a $200 million loss when they were forced to sell back at a discount to face value notes used to finance a Clayton, Dubilier & Rice buyout of Cornerstone Building Brands. Most of the losses came from PIK debt. 

The US Treasury in 2020 agreed to allow Yellow, a trucking company formerly known as YRC Worldwide, to PIK part of the interest on a $300 million tranche of a $700 million loan. Yellow in August filed for bankruptcy protection, leaving the government’s ability to recover the PIK interest and other payments in question.  

In private debt, unless an investor asks, “it’s difficult to discern” if a manager is using PIK, says Apollo’s Vanek. PIK amendments are more apparent in public business development companies, where disclosure is greater.  

The number is rising there as well. In the first quarter, Fitch tallied PIKing at about 8.4 percent of interest and dividend income in the 20 BDCs it rates. That is considerably higher than the 3.6 percent recorded in 2019. 

“The question is, are the lenders just delaying the inevitable?” Neenan of Fitch asks. She notes that many BDCs haven’t been through a credit cycle but have a lot of exposure to 2021 and 2022 vintages that were originated in a very competitive environment. “There’s not a lot of cushion in those deals”, she says. 

“PIK is not meant to be a permanent solution for companies that are having real problems,” says Seward & Kissel’s Bateman. “At some point you have to pay the piper.”