The Components of Payment-in-Kind Interest in Private Credit

The COVID-19 pandemic and subsequent increases in interest rates strained businesses’ cash flows, but it also opened the opportunity for lenders to offer borrowers deferrals on cash interest payments. Markets are predicting the Federal Reserve will soon lower interest rates, which could change how private credit funds are managing their loans and give policymakers a better understanding of why payment-in-kind (PIK) interest is used in business development companies (BDCs).

The Securities and Exchange Commission (SEC) heavily regulates BDCs, which are publicly traded on stock exchanges. There are also nontraded BDCs that do not trade on stock exchanges. These vehicles invest mostly in small to midsized private businesses. Other types of private credit products include collateralized loan obligations (CLOs), interval funds, and closed-end funds that rely on institutional investors, such as pension funds and endowment funds. 

One recent article published by Bloomberg maligns one specific BDC in an effort to highlight potential risks in all BDCs. BDCs, however, offer stable yields and low risk even as they have grown exponentially over the years. According to S&P Global, of the BDCs they rate, the vehicles consist of “low leverage, diversified funding mixes, limited loss experience and affiliations with broader asset managers.” Idiosyncratic components of specific BDCs cannot and should not be attributed to all BDCs. It would even be more ludicrous to attribute one BDC’s financing to all private credit funds—considering that BDCs only make up a fraction of the $1.5 trillion private credit market.

One of the components of BDC loans that is discussed in the Bloomberg article is PIK interest. PIK interest allows borrowers to defer cash payment on interest until the maturity date of the loan. While there is a risk that a borrower may not be able to pay the accrued debt at the time of loan maturity, future shifts in monetary policy should alleviate debt burdens on borrowers. In September, the Fed will likely lower the federal funds rate by 25 basis points. The loans held by private credit funds are primarily senior secured and floating rate loans. As the federal funds rate declines, so will interest rates on middle market loans. Additionally, the senior secured nature of many of these loans gives investors priority over bondholders and shareholders in the event of a default—the worst case scenario. 

While PIK interest has increased over the past few years, it still only makes up on average about 8 percent of the overall interest income received by BDCs. One benefit of PIK interest is that “the conversion to PIK interests do not typically affect overall returns.” The PIK option even “offers a yield premium.” The seamless transition to PIK interest in loan contracts also helps prevent loan impairments by avoiding loan restructuring “during liquidity shortages.” While disallowing PIK interest would ease the minds of certain skeptics, it could also limit credit access for businesses. Lenders may not want to issue loans given a company’s particular cash flows if PIK interest is off the table. PIK interest allows for flexibility in loan contracts between lenders and borrowers and thus opens the door for financing that otherwise might not exist. 

There are also safeguards written into private credit agreements to maximize the benefits of PIK interest payments. Lenders and borrowers may agree to a maximum amount of PIK interest and a minimum amount of cash that a borrower must put forward in a payment period. There are also usually limits on when PIK interest can be “toggled” to ensure it is not abused. 

Instead of wantonly criticizing PIK interest, policymakers should aim to understand monetary policy’s effect on PIK interest. Policymakers should also clearly acknowledge that PIK interest can serve as a tool to expand allocations of credit that would otherwise cease to exist. Slapdash critiques of PIK interest fail to account for why PIK exists in the first place—to facilitate innovative financing to businesses that might not otherwise be able to access credit.