Private-credit PIK provisions fall to 13.5% as shadow defaults mount

Private-credit firms are clamping down on payment-in-kind provisions, with 13.5 percent of new loans originated in the second quarter carrying the interest-deferral feature, down from 25 percent at the end of last year, according to Lincoln International.

"This is an evolution we are seeing unfolding now," said Brian Garfield, managing director at Lincoln International. "The pendulum is shifting."

The pullback follows a wave of deferred-interest requests from cash-strapped borrowers, including companies that sought PIK relief after taking out loans. About 11 percent of outstanding private-credit loans had partial or full PIK as of the second quarter, up from 7 percent at the end of 2021. More than half of those deferments were agreed to after loan origination — what Fitch Ratings counts as defaults and industry insiders call "shadow defaults."

The tightening comes after Medallia, a software firm with roughly $2.8 billion in debt, was taken over by creditors led by Blackstone, KKR and Apollo this month. Thoma Bravo, Medallia's private-equity owner, and its investors lost about $5 billion when their equity was wiped out. The collapse has intensified scrutiny of private credit from wealthy individual investors, who are increasingly questioning allocations to the asset class.

Medallia's $2.8B Collapse Reshapes Lending Terms

Medallia had been delaying interest payments for about four years before its takeover, using PIK provisions to defer obligations that had ballooned to roughly $2.8 billion. Thoma Bravo tried to get lenders to further extend the deferred interest period, but that effort failed. Lenders opted not to extend the deferrals in part after Thoma Bravo decided not to commit more equity to the company.

Blackstone didn't move Medallia to nonaccrual status — indicating it no longer expected full repayment — until early this year. The delay illustrates how PIK provisions can mask deteriorating credit quality for extended periods.

PIK Income Masks Deteriorating Loan Quality

The PIK pullback is part of a broader tightening of lending standards across private credit. Firms are extending less debt to borrowers being bought out by private-equity firms, especially software companies and others vulnerable to disruption by artificial intelligence. They are also closing loopholes that allow financing against borrowers' assets.

Pluralsight, a tech-skills learning platform, was bought by Vista Equity Partners in 2021 with debt from lenders including Blue Owl, Ares Management, BlackRock and Goldman Sachs. By 2024, lenders were in talks to restructure it, and interest deferrals kicked in. Vista wrote off its equity investment and transferred ownership to the lenders.

Private-credit executives say it is getting harder for underperforming companies to get loan modifications that allow them to defer interest payments, or to extend those deferrals, unless their private-equity owners make sizable concessions to satisfy lenders. The decline of PIK provisions is partly due to fewer deals being made for software firms like Medallia, where deferred interest is more common.

Lenders count PIK as income even though borrowers are essentially giving them an IOU — and this has ticked up as a share of firms' total interest income. Loans within publicly traded business-development companies, which are marketed to individual investors, that have been materially modified after origination have been hovering near their highest levels in at least a decade. The more interest that is temporarily deferred, the higher the likelihood the borrower will default, according to a report by Raymond James.

Deferrals exist across deals where private-equity firms use debt to buy companies, including radiology companies, consumer-lending platforms and property maintenance firms. The shift in lending standards carries direct implications for the broader leveraged finance ecosystem. If lenders continue to pull back on PIK provisions and other loan sweeteners, deal flow in leveraged buyouts could slow further, particularly in the software sector. For investors in business-development companies and private-credit funds, the tightening means the era of easy loan terms is ending — and the true cost of deferred interest is finally being priced in.

This article is for informational purposes only and does not constitute investment advice.