This report covers four important topics in direct lending, as well as what to look out for, and how to assess a manager’s approach to these elements of the private credit investment landscape.
- Payment-in-kind (PIK) interest in deals
- Liability management exercises (LME) among deal participants
- Convergence of the public and private credit markets
- Deal flow
1. PIKs
Payment-in-kind (PIK) interest is essentially when a borrower either cannot or chooses not to pay the cash interest due on its loans. Instead, they capitalize the interest, increasing the principal amount of the loan. There are two ways PIK may become a reality in loans: 1. Some amount of PIK is permitted in the original documents, or 2. It is amended into the documents post-close. PIK in a credit agreement is usually limited to the first two years of the loan and 50% of the spread. For instance, if the loan is S+500, which is a 500-basis point (bp) spread above the Secured Overnight Financing Rate (SOFR), then 250 bps can be PIKed for the first two years of the loan. To do this, borrowers pay a penalty to discourage its use, unless there is a real need.
While PIK can be viewed as unfavorable because it can indicate financial stress, there are cases where it fits the credit at the time of origination. This type of PIK is typically used for companies with a strong brand or product and high growth potential, even if they are pre-profitability or in the early stages of profitability. In such cases, the company may be tight on liquidity in the short term, but from a credit perspective, it is still a strong investment. A well-resourced private credit manager with selective origination capabilities should be able to identify these credits that could potentially benefit from this type of loan provision.
Conversely, some types of PIKs are requested by borrowers simply because market conditions permit it. The prevalence of PIK is indicative of a broader market trend where private loan documents need to be more flexible to compete with broadly syndicated loan (BSL) documents. The most concerning scenario, which can be a significant red flag, is when a loan was originally structured without PIK but gets amended to include it halfway through its term due to emerging liquidity problems.
This debate around PIK is particularly relevant now because the amount of PIK in direct lending portfolios has increased significantly. Historically, PIK might have applied to about 5% of a portfolio or less. According to S&P Global, nearly 12% of loans held by Business Development Companies (BDCs) made PIK payments in the second quarter of 2024.1 This increase is largely due to base rates having risen by 400 to 500 bps, causing some issuers to struggle with managing higher interest expenses. In many of these situations, the flexibility provided by PIK is being used as a crutch rather than a strategic tool. When evaluating private credit strategies, allocators should ensure they understand the extent of PIK exposure in the strategy, and how the manager addresses this risk.
2. LMEs
Liability management exercises (LMEs) are a very important topic that has evolved dramatically post-COVID-19 and continues to do so. Also known as “lender-on-lender violence”, LME involves a restructuring that disadvantages one part of the capital structure relative to others, and in some cases, even pits the holders of the same instrument against one another, with significant consequences for the debt holders on the losing end of the process. This has also resulted in unfavorable outcomes for lenders.
Specifically, when discussing LMEs, it is important to be specific about the adverse scenarios that can occur. These include the stripping of collateral, the addition of new debt that supersedes what was initially considered senior debt, and the release of credit support from subsidiaries, among other scenarios. Each of these factors can significantly undermine loan recoveries, highlighting the risks that LMEs present to lenders.
Similar to PIK, there is a vintage element to LME, reflecting the history of direct lending. Historically, direct lending documents did not permit LMEs that would result in different treatment for lenders in the same tranche of a loan. However, this has evolved as the direct lending markets have changed. Pre-COVID-19, direct lending was primarily for companies that did not have access to the capital markets, typically middle market companies. Post-COVID-19, the capital markets dislocated, coinciding with significant capital raising around direct lending due to historic performance and investors' search for yield. This led to direct lending being used by larger companies that traditionally had access to the capital markets.
As direct lending has moved up market, documents for these loans have become less conservative in order to compete with broadly syndicated loans. This has brought LME into the spotlight in recent years.
Recent court cases, such as the 5th Circuit overturning the bankruptcy restructuring of Serta on New Year's Eve of 2024, have been minority-lender friendly.2 Now, the market is more aware of what is at stake, the terms, and the language to look for to prevent these transactions. This has led to more transparent discussions when issuing new loans, focusing on what is allowed in terms of subjugation of collateral, removal of collateral, or differentiation of lenders.
There may still be a large number of loans in historic funds and portfolios (especially the 2020–2021 timeframe) with documents that permit LME to some degree. For these older deals, LME likely will continue to be seen. However, for newer deals, there generally has been more discipline, and the LME-type provisions have been tighter, especially in the middle market where the documents have not been intended to compete with the broadly syndicated loan market.
The existence of LMEs may be considered a negative for the overall marketplace, but the good news is that the market is beginning to recognize this, and many more restrictions have been implemented.
3. Convergence of the Public and Private Credit Markets
A newer but consistent trend in the lending market is this idea of flexibility. Borrowers are beginning to recognize that even if they have access to public markets, there are times when the broadly syndicated loan market can shut down, and so the need to have relationships in the private markets may be critical. As this trend evolves, so has the level of sophistication and awareness by not only the borrowers, but also the sponsor universe. As a leader of a corporation, such as a CEO or CFO, it is important to understand that liquid markets and private markets do not always move in tandem. Therefore, having a presence in both markets may be essential.
Additionally, there are other compelling reasons to use private lending, even for a large company with access to the capital markets. Confidentiality can be critical in certain situations, and a company might prefer to engage with one to five private lenders to keep the information tight. Customization is another factor. A very complicated capital structure might be difficult for rating agencies or the broader liquid market to understand. In such cases, you can work with one or two private lenders who can provide a tailored solution.
These trends and use cases have always existed and will likely continue to increase. The market has been discussing the strong trend toward private finance. One related indicator is the reduction in the number of publicly listed companies. While this is not a direct indicator, as both publicly listed and non-publicly listed companies can use private credit, it does highlight the value of private capital. Private capital can be customized, remain confidential, and have a longer-term focus, which is highly valued by companies.
It is also important to recognize that there are two very distinct ecosystems within direct lending. One is the historic use of direct lending that involves financing companies that do not have access to the capital markets. This remains unchanged and is characterized by tens of thousands of companies and hundreds to thousands of sponsors in a space that no one can dominate. In this ecosystem, you are not competing with the capital markets or many of your competitors on any one deal.
In contrast, there is the more recent development of the upper middle market. This involves direct lending used broadly for companies that are not middle market companies but have access to the capital markets. In this ecosystem, elements like PIK and LME, and different uses of M&A financing are more prevalent. This development highlights the imperative need for managers to have deep resources, not only in direct lending, but also deep expertise in the public markets. Having relevance across the public and private credit spectrum, combined with patient capital, is the key to success in middle market direct lending today.
4. Deal Flow
It is important to frame the currently muted deal flow environment within the context of higher rates. When rates increased in 2022, deal activity declined across the capital markets. The reason for this is that an increase in rates also raises the discount rate on the value of a company. For instance, if you're a private equity firm showcasing something in your portfolio, you might think it's worth 12 times earnings before interest, taxes, depreciation, and amortization (EBITDA) when base rates are 25 bps. However, when base rates rise to 525 bps, that valuation might drop to 8 times EBITDA. Consequently, there has been an inclination for owners of enterprises to wait for rates to come down.
By late 2024, there was a growing consensus, perhaps even capitulation, that rates were going to remain higher for longer. This led to a reduction in the disparity of views between buyers and sellers. The anticipation was that with the new administration, capital markets would be more active. However, the administration has behaved differently than the market expected. Before January, we were already predicting a thaw in deal activity, likely toward the end of the year, in the third or fourth quarter. Given recent developments, we now believe that this thaw is another two quarters away.
What is encouraging is that the environment for lenders has remained relatively healthy. Although deal activity will naturally fluctuate, we believe it is essential to choose a manager with broad origination capabilities and the resources to cover lower middle market, core middle market, and upper middle market segments. A manager with the right amount of capital can deploy effectively regardless of market conditions to capitalize on opportunities even in fluctuating environments.