"Interest Added to Principal Became a Bomb"... U.S. Private Credit Sees Sharp Decline in PIK Loans

[Mexico City = Shim Young-jae, Correspondent] In the U.S. private credit market, the number of Payment-in-Kind (PIK) loans, which allow borrowers to add interest to the principal without paying cash interest, is rapidly decreasing. This decline is attributed to an increase in companies requesting PIK after taking out loans due to financial difficulties, raising concerns about the so-called 'shadow defaults' where actual bankruptcy risks may be higher than official statistics indicate.

According to the Wall Street Journal (WSJ), on the 11th (local time), a report by investment banking advisory firm Lincoln International indicated that in the second quarter of this year, the proportion of new private credit loans that included PIK provisions was 13.5%, down from nearly 25% at the end of last year.

Reduction of PIK... Lenders' Negotiating Power Grows Again

PIK allows borrowers to defer cash interest payments and add them to the loan principal to be repaid later.

As competition in the private credit market has intensified, PIK has spread as a major incentive to secure loan transactions. Even if borrowers do not actually pay cash interest, it could be treated as if they are making normal interest payments under the loan agreement.

The problem is that there has been an increase in cases where companies, facing deteriorating financial conditions, request new deferrals of interest payments after taking out loans, beyond those where PIK was included from the start.

Some private credit industry insiders and lawyers have begun to view this as a signal of potential loan defaults.

Brian Garfield, Managing Director at Lincoln International, stated, "The changes currently unfolding" and noted that there is a shift towards negotiating with institutions that provide additional loans.

According to WSJ, the overall lending standards in the private credit industry are also tightening.

This is due to worsening loan performance and increased scrutiny from investors. Some investors, including individual investors, are reassessing how much capital to allocate to private credit.

Lending institutions are also reducing the amount of debt provided when private equity firms acquire companies. In particular, lending standards are tightening in certain sectors, including software companies vulnerable to changes brought about by artificial intelligence (AI).

There is also a trend to reduce contractual loopholes that allowed borrowers to raise additional funds using their assets.

"Adding Interest to Principal"... Debt Continues to Rise

While PIK alleviates immediate interest burdens for cash-strapped companies, it does not eliminate the debt itself.

This is because the deferred interest is added to the principal. The longer PIK is used, the greater the overall debt of the company becomes. Therefore, newly permitted PIK after a loan is executed is assessed as a more serious warning sign.

WSJ reports that some refer to these cases as 'shadow defaults.'

Credit rating agency Fitch classifies PIK allowed after loan execution as a default.

According to Lincoln International, about 11% of all private credit loans in the second quarter of this year utilized some or all PIK structures. Although this percentage has slightly decreased since the beginning of the year, it remains high compared to 7% at the end of 2021.

More importantly, over half of the interest payment deferrals were agreed upon after the initial loan execution.

In the private credit market, this type of post-contract modification allowing interest deferrals is referred to as 'bad PIK.'

Some market participants believe that without these changes in loan conditions, the official default rate in the private credit market would have appeared higher than it currently does.

This is because even after lenders allow PIK, they can classify the loan as normal for a considerable period. It is only when they determine that it will be difficult to recover all principal and interest that they can switch it to a nonaccrual loan.

Medallia Defers Interest for Four Years... Debt Reaches $2.8 Billion

The case of customer experience software company Medallia is presented as a representative example of PIK risk.

According to WSJ, Medallia deferred some interest payments for about four years before its management rights were transferred to creditors. During that time, its debt ballooned to approximately $2.8 billion.

The acquisition of Medallia by its creditors was completed this month.

Blackstone led the creditor group, with KKR and Apollo also participating.

Medallia's private equity major shareholder, Thomas Bravo, requested an extension of the interest payment deferral period from lenders before defaulting, but it was ultimately not accepted.

WSJ reported that the debt incurred during the PIK and acquisition process affected Medallia's overall debt increase.

With the acquisition by creditors, the shares held by Thomas Bravo and investors were completely wiped out, resulting in a loss of about $5 billion.

Blackstone only converted Medallia's loan to nonaccrual status earlier this year.

WSJ explains that part of the decline in PIK is also due to a reduction in new transactions involving software companies like Medallia. PIK has been relatively widely used in software company acquisition financing.

Recognizing Income Without Receiving Interest

Another controversy surrounding PIK is the accounting method for recognizing income by private credit managers.

According to WSJ, private credit lending institutions recognize PIK interest as income even if they have not actually received cash from borrowers.

This structure is similar to borrowers providing a promissory note indicating they will pay in the future, but it is included in the accounting interest income. The proportion of such PIK in the overall interest income of private credit managers has also increased.

A report by Raymond James indicates that the larger the proportion of temporarily deferred interest, the higher the likelihood that the borrower will ultimately default.

While PIK is decreasing in new loans, there remains a significant amount of interest deferrals in existing loans that have already been executed.

Among the loans held by publicly traded business development companies (BDCs) sold to individual investors, the proportion of loans with significantly changed conditions after execution is approaching the highest level in the last ten years.

The PIK issue is not limited to software companies.

According to WSJ, interest payment deferrals are appearing in various sectors among transactions where private equity firms have used debt to acquire companies, including radiation-related companies, consumer loan platforms, and real estate maintenance companies.

Pluralsight Also Transferred to Creditors

The technology education platform Pluralsight underwent a similar process.

Vista Equity Partners acquired Pluralsight in 2021. This transaction utilized debt provided by lenders such as Blue Owl, Ares Management, BlackRock, and Goldman Sachs.

According to WSJ, in 2024, creditors began discussing the restructuring of Pluralsight's loans, and interest payment deferrals also began.

Ultimately, Vista wrote off the entire value of its investment in Pluralsight and transferred ownership of the company to creditors.

As these cases repeat, lending institutions are demanding stricter conditions for allowing new PIK or extending existing deferral periods for underperforming companies.

Private credit industry insiders explain that unless private equity major shareholders provide significant concessions, it is becoming more difficult for distressed companies to receive changes in loan conditions, including interest payment deferrals, than before.

This change is also evident in the Medallia case.

According to WSJ, one of the reasons lenders did not extend Medallia's PIK period further was Thomas Bravo's decision not to inject additional equity into the company.

In the private credit market, PIK was once used as a flexible financial condition to attract borrowers in competitive transactions. However, as underperforming companies increasingly rely on PIK due to their inability to bear existing cash interest, the market's perspective is changing.

The sharp decline in the proportion of new PIK loans from 25% at the end of last year to 13.5% in the second quarter of this year signals that lending institutions are beginning to distinguish between simple interest payment deferrals and actual credit deterioration. At the same time, the fact that 11% of existing loans still utilize PIK, with more than half of those conditions added after loan execution, indicates that the potential distress in the private credit market has not yet been resolved.

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