Brookfield Oaktree says payment-in-kind trend is “worth monitoring” for risks ahead
A growing number of borrowers are turning to payment-in-kind (PIK) loans for interest payment flexibility as rates remain high, according to Brookfield Oaktree.
The asset manager’s latest quarterly Alts Market Dashboard highlighted the phenomenon among the top themes of the first quarter of 2024.
PIK enables a borrower to make interest payments in a form other than cash, such as additional debt or equity, during the term of the loan.
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“It is critical to understand not just whether a borrower has turned to PIK but why they have done so, and whether the underlying business is still sound,” the report said.
“For example, some borrowers use PIK from the point of loan origination when they are first pursuing financing for their operations and the underlying business model is nonetheless healthy. Others turn to it as an amendment to the agreement during the life of the loan in times of stress or when they can’t afford interest payments anymore.”
While some PIK is not a major concern, it is a trend that Brookfield Oaktree recommends monitoring.
“When it takes the form of equity, it can dilute shareholder equity,” the report said. “The risk for lenders is that the accrued interest is never received. On the other hand, the upside for lenders is that PIK increases the yield on a loan, potentially boosting returns.
“While some PIK is generally not considered to be a major concern, it can add to the potential riskiness of the loan by increasing the debt load. As such, it remains a trend worth monitoring because it can be one indicator of potential portfolio issues ahead.”
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The report cited recent research from S&P Global Rating that predicts that the use of PIK will increase into next year as companies struggle to keep up with their debt obligations amid high rates. There is also a large amount of debt that will need to be refinanced in the next few years
The Alts Market Dashboard highlighted that borrowers may struggle to find financing via syndicated bank loans because bank loans are mostly sold into collateralised loan obligations (CLO). As CLO issuance declines, a growing number of borrowers are expected to look to private credit solutions.
“For investors, the increasing incidence of PIK is perhaps more than anything a reminder of the importance of working with a private credit manager with a proven track record of navigating economic cycles and being prudent about how and when to use a feature such as PIK in a portfolio,” the report said.
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