Of Principal Interest
Credit Market Insights by Antares
Synthetic PIK –
What is it and should investors be concerned?
Cash is fungible and synthetic PIK may be no worse than traditional PIK from a credit perspective, but synthetic PIK is not reported as PIK and therefore could mask brewing credit issues for some lenders.
ABCs of PIK
“PIK” stands for “Payment In-Kind” and is an option that can be granted to borrowers that allows them to make part or all of their interest payments over a period of time by adding to their principal due at maturity instead of making cash-based interest payments. Offering a PIK option can be a competitive advantage for direct lenders because PIK is far less common in the broadly syndicated loan (BSL) market.
Sometimes, a PIK option is included upfront at the initial origination of the loan to allow borrowers greater flexibility to pay back debt. Exercising a PIK option comes with a premium, but borrowers may judge the extra cost to be worthwhile in certain circumstances. For example, although a fast-growing tech company may have the ability to cut their marketing and R&D costs to make their interest payments,
they may judge that they are better served incurring the extra cost to PIK their debt so as not to detract from
investment in their future growth. This might be deemed a “healthy” use of PIK and would not be deemed to be a default by a credit rating agency.
In other cases, a PIK option is included via an amendment in the wake of current or anticipated cash flow stress with the aim of helping the borrower avoid payment default.
The ability to constructively negotiate such relief (often with injections of equity and additional fees) is part of private credit’s appeal to borrowers vs. public markets. However, PIK in this case reflects credit stress that would typically result in the mark down of a loans valuation.
Enter Synthetic PIK…the new turkey bacon?
In contrast to traditional PIK, synthetic PIK allows borrowers to pay interest in cash instead of making a non-cash “in kind” payment. This is achieved by creating a smaller delayed draw term loan – also known as the synthetic interest payment facility (SIPF) – for the explicit purpose of allowing the borrower to draw down funds to pay cash interest on the primary loan. The SIPF is typically “pari passu” with the primary debt tranche, but the exact pricing, fee arrangements, and other terms of synthetic PIK deals can vary significantly. Most appear to be offered in the upper middle market transactions vs. core or lower middle market at present.
Some lenders lament the use of the term “synthetic” as having a pejorative connotation of ill-conceived financial engineering and note that not all “synthetic” things are necessarily less healthy (like turkey bacon vs. pork bacon). At least from a lender perspective benefits of synthetic PIK include:
- Interest payments in cash improves cash NII dividend and interest coverage ratios.
- Avoiding the trigger of a bank’s or debt facility provider’s cap on PIK that could limit a fund’s access to leverage.
PIK your poison
Antares acknowledges that cash is fungible and that the pure credit impact of synthetic vs. traditional PIK on a stand-alone basis is immaterial (all else equal on terms); however, in either case, high levels of PIK remains a cause for concern (e.g. turkey bacon may be no worse than pork bacon, but that’s not to say it is health food). There is good reason why most traditional revolving credit and DDTL facilities restrict borrowers from drawing down funds to pay interest. Moreover, synthetic PIK is not reported as PIK and therefore its use may mask underlying credit problems that are not adequately reflected in loan valuations.
While Antares believes offering flexibility to borrowers is a hallmark of private credits value proposition, this consideration must be balanced against the requirements of sound credit management and stakeholder transparency.
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