Private Equity Stress Escalates with Surge in Deferred Interest Payments
According to a recent report from valuation firm Lincoln International, the share of private equity-backed companies that deferred cash interest payments has increased for the third quarter in a row, highlighting growing signs of financial stress in the sector.
Rising Trend in In-Kind Interest Payments
Data from Lincoln International reveals that 11% of borrowers in the fourth quarter opted to pay interest in-kind, a method where creditors receive additional debt instead of cash. More than 58% of these loans involved what is termed "bad PIK", meaning borrowers chose to delay interest payments during the loan's life rather than at its origination.
While private lenders typically avoid flexible covenants like PIK, including such provisions in initial agreements can help them secure deals in today's highly competitive credit market. An unexpected shift to in-kind payments often indicates mounting strain, such as a cash crunch, though it can sometimes be used strategically by borrowers seeking to allocate capital elsewhere.
Bad PIK Usage Hits Record Highs
Bad PIK was present in 6.4% of private loans last quarter, up from 6.1% in the previous three months and significantly higher than the 2.5% ratio recorded in the last quarter of 2021, when Lincoln began tracking this data. The firm, one of the largest providers of third-party loan valuations in the private credit industry, analyzed over 7,000 companies during the fourth quarter.
"There's been a lot of debate about our PIK analysis, but it all comes down to loan-to-value," said Ron Kahn, global co-head of valuations and opinions at Lincoln. "Companies we flagged as having bad PIK went from roughly 40/60 debt-to-equity, which is reasonable, to about 76% debt today — that's a sign of stress."
Impact on Debt and Lender Protection
Issuing bad PIK increases a company's debt burden without enhancing its value, leading to a rise in loan-to-value ratios that erodes lenders' downside protection. According to Lincoln, the average loan-to-value ratio for deals with bad PIK has remained above 75% since the fourth quarter of 2024, compared to just 47% in the same period in 2021.
Broader Market Concerns and Industry Focus
Amid a broader selloff in the software industry, even the largest business development companies are closely monitoring their exposure to PIK in their portfolios. Kort Schnabel, CEO of Ares Capital Corp., noted a "slightly higher percentage of PIK" in the firm's software book last quarter, but emphasized that the vast majority was planned from the outset.
"The PIK in that software book is, I want to say, 99%, maybe even 100%, structured at the upfront, at the outset of the investment," Schnabel told analysts last week.
This trend underscores the increasing financial pressures within private equity, as more companies resort to deferring payments to manage cash flow challenges.
