Growing risks from payment-in-kind debt draw watchdog scrutiny 

THE International Monetary Fund (IMF) is planning a deep dive on the growing prevalence of payment-in-kind (PIK) debt that allows companies to defer interest payments, amid wider fears that the tool could undermine financial stability by obscuring stress. 

The watchdog plans to look at how often the expensive debt used to keep struggling companies alive is in fact merely delaying an inevitable insolvency, according to a person with knowledge of the matter.

The IMF also plans to look at interconnections between banks and private credit after a series of lending partnerships were announced recently, the person added, asking not to be identified as they were not authorised to speak publicly.

Watchdogs across the world are concerned about the risk of bubbles in private markets against a backdrop of inflated asset values, high interest rates, and a rush-for-cash among firms battling to build scale.

PIK has become an increasing area of focus, sweeping to prominence as private equity firms sought ways to manage higher-than-expected interest payments amid a prolonged period of higher rates. 

The IMF work comes amid rising concerns about potential systemic risk from the growth of private credit.

Of particular interest to the watchdog, the person said, is understanding the different layers of leverage in the financial ecosystem.

Investors might borrow to help fund their allocations to private credit funds, which in turn might have leverage on their portfolios. And ultimately the money is flowing to companies getting loans from these funds. 

The increased use of PIK can be seen by looking at a sample of business development companies, a type of private credit fund.

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PIK averaged more than 20 per cent of their net investment income in the third quarter, according to data compiled by Bloomberg Intelligence, an increase of six percentage points in a year. 

Despite the cost, this form of leverage has found favour with private market players because it can boost overall portfolio returns even when some individual loans are suffering. That could flatter performance and aid with fundraising.

The rise of PIK is raising eyebrows among traditional banks too – a senior European investment banker said that the phenomenon was a key point of difference between the business his bank does and private credit.

While defaults remain low, the watchdog is mulling how much of that is related to extend and pretend, a tactic of avoiding defaults that can include pushing out maturities or using additional debt such as PIK.

The fear is that if delaying the stress proves unsustainable, it might trigger a crisis of confidence in the whole private credit sector, with a broader impact on the economy.

“PIK will remain in focus especially if we remain in a higher-for-longer environment,” JPMorgan Chase analysts Kabir Caprihan and Vincent Barretta wrote in a report last month. “It is harder for the market to get a full grasp on the amount of PIK” because it is also often used by growing technology companies in their early years.

Danielle Poli, a portfolio manager at Oaktree Capital Management, also said it’s important to distinguish between the purposes of the debt.

“There’s a difference between PIKs offered outright in an initial deal, which is standard now, and older vintages which are adding PIK with the hope that lower rates may help those structures and help problems go away,” she said. “The data that’s out there doesn’t bifurcate between the two.”