Before software firm Medallia was taken over by creditors in a collapse that rattled the private-credit industry, it had been delaying interest payments for about four years on debt that had ballooned to some $2.8 billion.
The option it used to defer payments became a popular sweetener in the private-credit industry as competition to win deals ramped up, with borrowers deploying it often being considered up-to-date on their loans. Then, more borrowers began using the relief valve -- even including cash-strapped companies that requested it after taking out their loans -- raising fears of looming defaults.
Now, private-credit firms are clamping down on the option, known as payment in kind, or PIK.
Some 13.5% of new private-credit loans originated in the second quarter had a PIK provision, according to investment-banking adviser Lincoln International, down from 25% at the end of last year.
Lenders have a little more negotiating power than they used to, said Brian Garfield, managing director at Lincoln International. "This is an evolution we are seeing unfolding now," he said. "The pendulum is shifting."
Lending standards have been tightening across the private-credit industry, the result of worsening loan performance and increased scrutiny from investors, including wealthy individuals who are rethinking how much they invest in 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 -- and are closing loopholes that allow financing against borrowers' assets.
The pullback extends to PIK, which has become an essential feature for borrowers in need of a reprieve from payments. Some private-credit executives and lawyers increasingly see PIK as a sign that a loan could be at risk of souring, in part because the deferred interest is added to the principal balance, driving up the borrower's debt.
The more dire cases, such as when interest deferral is requested after the loan's origination, are seen by some in the industry as "shadow defaults." Fitch Ratings counts these PIKs granted after origination as defaults.
Medallia's takeover by its creditors, led by Blackstone and including KKR and Apollo, was completed this month . Before the default, Medallia's private-equity owner, Thoma Bravo, tried to get lenders to further extend the deferred interest period, an effort that ultimately failed. PIK and acquisitions made by Medallia contributed to its debt rising. Thoma Bravo and its investors lost about $5 billion when their equity position was wiped out with the takeover.
The decline of PIKs is partly due to fewer deals being made for software firms like Medallia, where deferred interest is more common.
Private-credit 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.
About 11% of outstanding private-credit loans had partial or full PIK as of the second quarter, according to Lincoln. The figure edged down a bit early this year and was up from 7% at the end of 2021.
More than half of those interest deferments were agreed to after the loan was originated, according to Lincoln. These are known in the industry as bad PIKs, since they are essentially loan modifications.
Some tracking the private-credit sector say that without these loan modifications, the climbing defaults in the industry would be higher. A loan can be in PIK for a while before a lender moves it to nonaccrual status, indicating that it no longer expects to get paid back in full. Blackstone, for example, didn't move Medallia to nonaccrual status until early this year.
The more interest that is temporarily deferred, the higher the likelihood the borrower will default, according to a report by Raymond James. Even as lenders pull back on offering PIK, there is still plenty of it on their existing loans. 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.
Deferrals exist across deals where private-equity firms use debt to buy companies, including radiology companies, consumer-lending platforms and property maintenance firms.
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 in Pluralsight and transferred ownership to the lenders.
Private-credit executives say it is also 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.
That played a role in Medallia's takeover. Lenders opted not to extend the company's interest deferrals in part after Thoma Bravo decided not to commit more equity to the company.
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