March 28, 2024 (MLN): Interests paid-in-kind (PIK) are likely to rise among private middle-market loans in the US through both amendments to existing loans and as an optionality in new loan originations, as the impact of higher rates fully kicks in and credit burden builds up among borrowers, says Fitch Ratings.
The rising competition from the broadly syndicated market will also pressure underwriting, particularly in the upper-middle market, and potentially incentivize PIK to be increasingly underwritten into new loan originations, since this is a benefit that private credit can offer relative to the syndicated market.
More middle-market firms may find themselves with insufficient interest coverage as high rates persist against a challenging economic landscape, pressuring liquidity and potentially leading to higher loan amendments, which often incorporate full or partial PIK interest for a set period.
This trend correlates with our expectation of another year of elevated default rates within our privately rated middle-market loan portfolio, as signaled by a higher proportion of issuers rated ‘CCC+’ or lower.
The portfolio recorded 13 defaults involving 10 issuers last year, predominantly through distressed debt exchanges, including missed interest payments or conversions to PIK, though we expect more in-court and out-of-court restructurings in 2024.
The growing competition from the broadly syndicated loan market could also influence direct loan underwriting, encouraging the incorporation of PIK terms into new loan agreements, as private credit can offer such features over the syndicated market as a competitive advantage, despite the often-associated yield premium.
We expect this increase in PIK, from already-high levels, could hurt the cash earnings coverage of business development companies’ (BDCs) dividends.
This is because PIK is collected in cash only upon final repayment. Some BDCs already exhibited cash earnings coverage below 100% despite strong growth in net investment income (NII) from higher rates due to elevated PIK income.
An increase in PIK may hit their cash earnings coverage ratios further, as BDCs will also face headwinds from spread compression, credit normalization and potential rate cuts in 2H24.
Still, Fitch expects the dividend coverage ratios of our rated BDCs, on a NII basis to remain solid.
Several BDCs have revised their distribution policies in recent years, splitting dividends into base and supplemental portions, with the latter paid on excess quarterly earnings and the former reflecting run-rate earnings across various market conditions.
Still, PIK will hurt NII if it merely postpones the recognition of credit losses and ultimately turns into non-accrual.
Fitch-rated BDCs saw higher PIK income during Covid-19 as various portfolio companies used it as a credit-management tool to preserve liquidity.
Several BDCs also invested in debt and preferred equity investments with embedded PIK features, keeping gross PIK income significantly higher than pre-pandemic levels at 8.3% of total interest and dividend income in 2023.
Blue Owl Technology Finance Corp. (BBB-/Stable) is at the high end of the peer group, with gross PIK comprising 21.8% of its interest and dividend income in 2023, indicative of its involvement in recurring revenue loans and investments with the rapidly growing software/tech sectors.
Other rated BDCs with high gross PIK income included New Mountain Finance Corp. (16.7%; BBB-/Stable), Blue Owl Capital Corporation III (15.1%; BBB-/Stable) and Ares Capital Corporation (14.8%; BBB/Positive), with Ares demonstrating a solid PIK collection history since its inception in 2004.
On the other hand, the conversion to PIK interests does not typically affect overall returns. In some instances, the availability of PIK at loan origination could even be favorable as it offers a yield premium.
While the PIK conversion during liquidity shortages could help reduce the likelihood of loan restructuring, which might otherwise impair the loan value.
Copyright Mettis Link News
Posted on: 2024-03-28T09:47:04+05:00
