Private credit fund investors face a growing risk that is hiding in plain sight—and now sometimes not in plain sight. Funds are increasingly adding interest payments back to loans in lieu of cash payments, potentially raising a red flag on an issuer’s ability to pay back its debt.
Default risk is a challenge to properly assess in private credit. The price of public corporate bonds often reflects the market’s assessment of this risk. Private loans, however, don’t have an active market to infer a changing risk profile. Private market investors are forced to consider metrics other than price to ascertain a fund’s current level of default risk.
Payment-in-kind isn’t a portfolio metric that appears on a fund’s factsheet or marketing materials. Investors must dig through each fund’s financial statements to pull it out. PIK exposure from a single point in time typically won’t reveal much, so expanding the data collection to peers and historical values quickly becomes prohibitive for investors.
To bring greater transparency, Morningstar Direct Platform users can now screen for this PIK income across semiliquid funds, such as unlisted business development companies. While there are still aspects of PIK that are harder to discern, the ability to screen for PIK income is a major step forward in fund selection and oversight.
Here, we start with PIK basics and go on to explain what those hard-to-discern aspects are, as well as identify some worrying PIK trends that investors should bear in mind.
PIK Basics
PIK means that, instead of making cash interest payments, a debt instrument is structured to make those payments in the form of more debt. In essence, the borrower is skipping cash payments and instead racking up more debt in exchange for the privilege. This flexibility is a major draw of private credit over public credit, at least for the companies borrowing the money.
How much of a portfolio is allocated to PIK debt has become especially important for direct lending funds, such as unlisted business development companies. That’s because the amount of PIK debt, and whether that figure has been changing, can be a cautionary signal.
PIK increasingly aligns lenders with borrowers for good or ill. The lender doesn’t collect any cash and instead increases the face value of the loan within its portfolio; the hope is to eventually earn that cash when the loan matures or is refinanced at the new, higher loan balance.
For the borrower, PIK is like skipping a credit card’s interest payment and adding it to the balance instead. The borrower pays nothing today but owes more tomorrow. For the lender, that larger lump sum means either a bigger future gain or loss, depending on whether the loan is paid back.
Unpacking PIK
Not all PIK is created equal. There are broadly two different ways that a loan ends up paying in-kind rather than in cash.
The first is called upfront PIK. It occurs when a loan is structured from the start to allow for PIK. Lenders may be willing to lend on a PIK basis if the loan is financing a project that isn’t expected to generate any cash for a certain period, such as the building of a data center. A loan financing data center construction might accept PIK terms early on and then mandate a switch to cash payments when the project begins to generate cash or after some contractually specified length of time.
Sometimes upfront PIK is structured to allow the borrower to “toggle” between cash and PIK rather than tying it to a specific length of time, thereby allowing the borrower to flip back and forth as the market and the business evolve. This kind of PIK is typically extended only to borrowers with comparatively strong financial footing, or when too many lenders are competing for too few deals, giving borrowers the upper hand in negotiations.
The second way is when a lender agrees to amend a loan to PIK status if a borrower with a previously cash-paying loan runs into trouble and needs to ask its lenders to accept PIK. While lenders may be able to decline that request, depending on restrictions within the original loan documents, it can be a difficult choice.
If that borrower misses an interest payment, it’s likely to show up as a default or nonaccrual in the portfolio, and the lender may be compelled to mark down the value of the loan. Offering flexibility is also a primary draw of private credit lenders who sell themselves on a willingness to customize loans, and disallowing PIK too often could lead to borrowers and their private equity sponsors taking their business elsewhere.
Unlisted BDC PIK Landscape
Morningstar Direct PIK data for the unlisted BDC universe provides some cause for concern. While PIK as a percentage of their income is low on average, it has been rising since December 2023.
The 10 largest unlisted BDCs all have payment-in-kind levels in the low- to midsingle digits, although there is still notable dispersion within that group.
While the largest unlisted BDCs tend to be in good shape, others report PIK well in excess of the average, including four in double digits.
Pay More, Later
PIK interest payments are inherently riskier than cash interest payments since the borrower is paying its interest by issuing more debt. That’s especially so when a heavily indebted borrower can’t pay the existing interest on its debt and so instead chooses to become more indebted. PIK exchanges a higher future debt burden in return for near-term flexibility. While PIK can give borrowers the flexibility to turn a business around, they can be left in an even worse spot if that fails—no turnaround, more debt.
Cash Flow Challenges
PIK isn’t just a risk because it increases a borrower’s debt burden. At high enough levels, it can also create a cash flow challenge for interval funds and unlisted BDCs. These funds are registered as regulated investment companies to avoid a second layer of federal income tax on their distributed earnings, which are already taxed at the investor level. To maintain RIC status, they must distribute at least 90% of the investment income generated by the portfolio to shareholders.
That’s true whether the income is cash or PIK. In other words, PIK counts as income to a portfolio when calculating its required 90% distribution, even though the fund has not received any cash from the borrower. It’s phantom income.
Suppose a fund reports $100 of income and must distribute $90. If $10 of the income comes in PIK form and the other $90 is received in cash, the fund has exactly enough cash income to cover the distribution. But if $15 is PIK, the fund receives only $85 in cash while needing to distribute $90. That leaves a $5 shortfall.
This does not necessarily mean the fund will have trouble making its distribution. It can obtain cash from other loan repayments, refinancings, new investor inflows, selling loans, or even borrowing money from a bank. Those choices come with trade-offs, though, as borrowing adds portfolio leverage, while the other options leave less cash available for new investments or shareholder redemptions.
Synthetic PIK
Markets are always evolving, and PIK is no exception. Regular PIK can create cash flow issues, as just described, and it’s transparent in SEC filings, where it’s called out as a component of income. To solve the cash flow problem, the private credit industry has created something called synthetic PIK. Unfortunately, this has also made PIK less transparent.
With regular PIK, the interest is paid by growing the balance of the original loan. With synthetic PIK, a second loan is made to the borrower, who uses that new money to cover—in cash—the interest payments on the original loan.
Synthetic PIK is like using a second credit card to pay the interest—and only the interest—on the first credit card. Of course, then the interest starts ticking on the second card, too.
The second loan used to facilitate synthetic PIK is often a delayed draw term loan or a revolver. Rather than borrowing money in one lump sum, like a traditional loan, DDTLs and revolvers allow the company to periodically borrow in discrete amounts, such as the exact amount required to pay the interest on the first loan.
Critically, because the interest payments on the original loan in a portfolio are still being delivered in cash, a fund holding the loan doesn’t record the payment as PIK income. eliminating problems for a fund trying to manage its cash flow. If the second loan has the same interest rate as the original loan, then the borrower’s total debt outstanding grows at the same rate as if it were a regular PIK structure, and its total interest cost remains the same. The difference is entirely in the optics, in what gets labeled PIK income versus cash interest income.
The labeling difference is material, though. It makes managing cash flows easier for the private credit fund manager. It also allows the manager to get around PIK restrictions in structures such as collateralized loan obligations, which often limit PIK loans to 5% or less of assets. CLOs are a major source of financing for BDCs, so too much observable PIK income can restrict a BDC’s access to fresh capital.
Defending Synthetic PIK
To give the market some credit, there can be real advantages to synthetic PIK over regular PIK. The DDTL often comes with conditions that function like a gate controlled by the lender. There are minimum draw amounts, a finite availability period, and covenant compliance requirements. Sometimes DDTLs require a sponsor to contribute new equity to the company every time money is drawn. There are also often fees on undrawn capital, which means the lender is earning a return even when the borrower isn’t using the DDTL.
What to Make of PIK
PIK grants borrowers greater flexibility to navigate the business cycle and their own changing fortunes, which is the main draw of private credit over public credit. This flexibility can keep returns high for investors in semiliquid private credit funds, but it also makes it harder to know the overall health of a fund’s portfolio because loans of PIK-paying borrowers often remain marked at or near par.
Therefore, the level of PIK as a percent of total investment income is an effective way to monitor PIK-associated risks in a portfolio, and that data is available to Morningstar Direct users today. Among unlisted BDCs, PIK income has been growing since December 2023, though it remains contained on average.
Unfortunately, the development of synthetic PIK represents a step away from transparency, as it’s not disclosed in filings and not included in Morningstar’s PIK data collections to date. Synthetic PIK maintains flexibility for the borrower while extending it to the portfolio manager. But it does so at the expense of shareholders, potentially trading away their long-term confidence to gain a little short-term flexibility.
