Private Credit Has a New Workaround to Allow Borrowers to Defer Interest Payments

(Bloomberg) -- A controversial lending structure that lets companies pay interest with more debt is getting a new spin from private credit.

Direct lenders including Blue Owl Capital Inc. have pitched deals in recent weeks that include a “synthetic PIK,” a feature that lets companies make some of the interest payments with additional borrowing without having to count the debt as being serviced “in kind,” according to people with knowledge of the matter.

“Payment in kind” lets borrowers make some or all of their loan interest payments by increasing the principal amount rather than using cash. That flexibility is in high demand as the Federal Reserve’s policy-tightening cycle has made it more difficult for heavily indebted companies to service their debt. Private credit funds are well-positioned to provide PIKs, and they’ve often used them to beat out banks when competing to provide financing to companies.

But there are limits. Big banks that help fund the lending activities of private credit firms typically cap the amount of such PIK deals they will finance. Synthetic PIKs are a workaround to those constraints.

This concept isn’t entirely new. It’s been seen a handful of times in recent years, especially with tech companies that are both burning cash and have recurring revenue from sources like contracts. Synthetic PIKs can help them meet interest requirements while they grow into a stable balance sheet.

In recent weeks, direct lenders have been pitching the synthetic PIK feature in deals where the company is more established and not burning cash, said the people, who asked not to be named discussing private information. The exact specifics of each deal varies and market watchers are still waiting to see if this feature remains intact as the deals are negotiated.

A representative for Blue Owl declined to comment.

Synthetic Feature

In a synthetic PIK, lenders provide a company two separate pieces of debt: the main loan the company planned to borrow in the first place, plus a smaller delayed-draw term loan that sits at the same level in the capital structure and has similar terms. Delayed-draw means a borrower has access to the full amount of that loan when the deal closes, but can choose to actually borrow the money at a later date.

When interest on the first loan needs to be paid, the company taps the delayed-draw term loan. This allows the company to pay the interest in cash, but it’s technically doing so through adding more debt to its balance sheet. In most cases, the synthetic PIK is used only for a portion of the interest.

There are two main advantages for direct lenders to use this structure.

The first has to do with how private credit funds operate. Individual funds often borrow from banks to increase the amount of cash they have available to lend. Those facilities are backed by the loans held in the fund and typically don’t exceed a ratio of around one-to-one with the equity capital of the fund.

Banks can impose terms on the facilities, including a cap on the share of PIKs in the portfolio, which helps guard against an excess of lower-quality credits in the collateral pool. However, synthetic PIKs don’t count toward the cap, the people said.

The second advantage concerns rules on Business Development Companies, a common private credit retail product. BDCs must pay out 90% of taxable income in cash, even when that income comes from payments-in-kind.

An excess of PIKs in a portfolio leaves funds at risk of not having enough cash to pay dividends. But because synthetic PIKs allow interest to be paid in cash, they reduce that risk.

--With assistance from Esteban Duarte.