Private Credit and the Rise of PIK Loans

PIK Me

PIK loans are a form of debt where the borrower typically accrues interest at a regular schedule, say every three or six months, but the borrower doesn’t pay cash interest. Rather, the interest just accrues during the term of the loan, and at maturity, the borrower pays back the principal and the accrued interest.This is a pretty simple structure, and usually these loans bear a high interest rate because these loans are risky. And many times, the lender in this case is a non-bank lender, like a private credit fund.

Why PIK?

Tenants often consider PIK loans for just a handful of reasons. The most common case is that it will use the loan proceeds as a form of growth capital. Lenders are not going to offer PIK loans to high-risk, cash-burning, venture backed startups. Rather they are seeking companies strained by more mature operations that are looking for capital that will not dilute shareholders nor require pesky cash interest payments. This allows the tenant to use that cash to reinvest in its business and grow or improve margins. The tenant’s end goal would then be to refinance this loan with some liquidity event in the future before the loan matures.

Be mindful of tenants that PIK their notes

The reality of PIK loans is that they signal a high-risk tenant, and landlords should be aware of the possible negative implications related to this form of financing. Lenders that originate PIK loans often have eyes on a big prize. That prize may be double digit returns if the note matures and is repaid, or it may be a new stake in a company’s capital structure. PIK notes are covenant light, which means they allow the borrower to be flexible, but in return lenders can exercise greater influence over the outcome. If a borrower is unable to refinance at maturity, the lender may seek something known as a distressed debt exchange, which would allow it to convert the debt into equity. This could result in a wider range of potential outcomes, some of which may be unfavorable to landlords, including possible tenant restructuring that could result in lease terminations.

Not all PIK loans result in trouble for landlords, but we want our clients to be aware of the risks and potential pitfalls of tenants carrying this increasingly adopted type of financing. If credit conditions continue to remain tight, we expect that there may be more instances of these loans in the market place as companies seek to avoid higher cash interest payments.