More private credit firms now accept higher-risk ‘payment in kind’ in direct-lending deals

[SINGAPORE] With higher-for-longer interest rates, regulatory capital requirements for banks and the lack of a robust public-debt market in Asia, more private companies turning to non-bank lenders for debt financing are exploring higher-risk “payment-in-kind” (PIK) options.

PIK allows borrowers to make interest payments in a form other than cash, such as by adding to the total debt or equity. For instance, interest could be added to the principal loan amount, to be paid off in full upon maturity of the loan.

In the private-credit space, PIK is typically reserved for the distressed and mezzanine segments on account of its higher risks. But now, private credit players are increasingly offering PIK in direct-lending deals.

“Historically, this feature was used almost exclusively in distressed or mezzanine transactions,” said Emmanuel Hadjidakis, principal at law firm Baker McKenzie Wong & Leow.

Preserve liquidity

“It is starting to be more commonly adopted in private credit and some senior financings in our region, given the high interest rate environment and in situations in which a borrower wants to preserve liquidity rather than pay interest,” he added.

Hadjidakis noted the risks to taking on PIK. For one thing, compounding debt could ultimately be too large or unsustainable for the borrower.

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But it also provides flexibility for borrowers, and allows lenders to differentiate themselves in tailoring transactions to suit the borrower.

Several variations of PIK have emerged in Asia, said Kaveeta Sandhu, partner at law firm Hogan Lovells.

For example, in a holding company PIK, interest is incurred at the holding company level; in a split PIK, a portion of the interest is accrued; in a toggle PIK, the borrower can choose between cash interest and PIK interest.

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Andrew Tan, chief executive officer for the Asia-Pacific at Muzinich & Co, noted that PIK deals are not new in Asia.

But now, people are asking for deals to be fully PIK, rather than with a cash portion, he said.

He noted that PIK has been linked to private-credit deals in distress in the West, as borrowers choose to defer the cash payment. But this might not always be the case.

“I think there has to be a distinction between the company choosing to PIK because they have spending obligations they want to prioritise – there has to be a distinction in terms of what is happening on the underlying,” said Tan.

There are ways that private-credit firms protect themselves against the PIK downside. For instance, they could offer PIK as part of a loan against collateralised assets, he added. To manage risks, borrowers are also required to report their financials to the lenders.

“If you are PIK-ing, you need to look at the underlying business to ensure that it’s at a healthy level to keep up with the amount of obligation that is back-ended,” said Tan.

For now, full PIK structures are not as evident in the Asia-Pacific, he added.

Lack of deep public-debt markets

In Asia, private credit’s expansion beyond special situations and mezzanine debt has been driven by factors such as regulatory capital pressures on banks, and the demand for development capital in the region. The lack of deep public-debt markets in Asia has also bolstered the expansion, said Thomas Kim, partner at Hogan Lovells.

Capital-intensive sectors such as infrastructure logistics and data centres are looking for new sources of quick, tailored and flexible credit, which banks might find challenging to accommodate.

Coupled with regulatory pressures and higher capital costs, banks have also retreated from providing small and medium-sized enterprises with credit, choosing instead to focus on investment-grade clients.

But as the adage goes: If you can’t beat them, join them. Banks are now also looking to raise dedicated pools of private-credit funds to invest into direct lending opportunities in Asia.

“By tapping third-party capital to make such loans, banks are able to shift higher-risk lending off the balance sheet and gain access to high-quality opportunities that may not fit their usual underwriting criteria – while staying relevant to the financing needs of their key client constituents,” said Kim.