Increasing risk resulting from the control of in-kind debt

The The International Monetary Fund (IMF) plans an in-depth review of the growing prevalence of debt in kind (PIK), which allows companies to defer interest payments, amid broader concerns that the tool could undermine financial stability by hiding stress.

The watchdog plans to examine how often expensive debt used to keep struggling companies afloat actually only delays inevitable insolvency, according to a person with knowledge of the matter. The IMF also plans to look at links between banks and private lending after recently announcing a series of lending partnerships, the person added, asking not to be named because they were not authorized to speak publicly.

Regulators around the world are concerned about the risk of private market bubbles amid inflated asset values, high interest rates and a rush for cash among companies struggling to scale. PIK has become an increasing area of ​​focus, gaining in importance as private equity firms have looked for ways to deal with higher-than-expected interest payments amid a prolonged period of higher interest rates.

The IMF’s work comes amid growing concerns about potential systemic risks from the growth of private credit. According to this person, the regulator is particularly interested in understanding the different layers of leverage in the financial ecosystem. Investors may borrow to finance their allocations to private credit funds, which in turn may impact their portfolios. And ultimately, the money flows to the companies that obtain loans from these funds.

The increase in the use of PIK can be observed in the example of business development companies, which are a type of private credit fund. PIK averaged more than 20 percent of its income from net investment in the third quarter, up six percentage points over the year, according to Bloomberg Intelligence data.

Despite the costs, this form of leverage has found favor with private market participants because it can increase the overall rate of return on a portfolio, even when some individual loans are suffering. This can flatter your results and help you raise funds.

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The emergence of PIK is also raising eyebrows among traditional banks – a senior European investment banker said the phenomenon was a key point of difference between his bank’s business and private lending. They asked to remain anonymous because they were not authorized to speak publicly.

While the number of insolvencies remains low, the regulator wonders how much of the situation has to do with extensions and fakings, which are insolvency avoidance tactics that may include pushing back maturities or using additional debt such as PIK. The fear is that if delaying stress proves unsustainable, it could trigger a crisis of confidence across the private credit sector, with a wider impact on the economy.

“PIK will remain in the spotlight, especially if we sustain higher levels for an extended period of time,” JPMorgan Chase analysts Kabir Caprihan and Vincent Barretta wrote last month. “It is more difficult for the market to fully understand the quantity of PIK” because it is often used by emerging technology companies in their early days.

Danielle Poli, portfolio manager at Oaktree Capital Management, also said it’s important to differentiate debt goals.

“There is a difference between PIKs being offered directly as part of the original contract, which is now the standard, and older vintages adding PIKs in the hope that lower rates can help these structures and help solve the problems,” she said. “The data that’s there doesn’t separate between them.” BLOOMBERG