(Bloomberg) -- A corner of the $850 billion private credit market is signaling pain may be on the way as lenders increasingly allow companies to make a risky type of loan amendment.
Business development companies, publicly traded firms that lend to smaller corporations, are tweaking their credit agreements to allow their borrowers to defer interest payments. Known as turning the loans into “payment-in-kind” obligations, the change can help borrowers conserve cash in the near term, while boosting their debt loads in the process.
In a report this month, Fitch Ratings said that while amendments can help portfolio companies navigate dislocations, “they could delay, or even exacerbate inevitable losses in some cases.”
The coronavirus pandemic has been a key driver of this most recent amendment surge in the $100 billion BDC industry. Income tied to PIK arrangements made up 9.7% of what the sector brought in during the second quarter of this year, up from 6.1% the previous quarter, according to Raymond James & Associates research. That’s still below the 13.6% peak reached in the middle of 2009 -- but approaching the 10% level it stayed above until late 2010.
“Past is prologue, and we saw some of this in the wake of the ‘08 financial crisis,” said Jennifer Daly, partner in the private credit and special situations investing group at law firm King & Spalding LLP. “When it comes to PIKs, they can be a life preserver or an anchor.”
Liquidity Mismatch
Lenders hope that by giving a borrower a temporary lifeline, they can stave off a restructuring or bankruptcy. “The ultimate danger would be that the company is never to fully recover and eventually pay that accrued interest in cash,” Fitch analyst Chelsea Richardson said in an interview.
And that can create liquidity issues for BDCs.
The vehicles are required under tax rules to distribute nearly all of their income to shareholders -- but if some of what they bring in isn’t actually cash, like under a PIK structure, it could leave the BDC struggling to raise cash to pay the dividend.
“There is a liquidity mismatch in our view for BDCs that are earning a higher portion of their income in non-cash earnings, but paying out a cash dividend,” Richardson said.
To be sure, some BDCs will fare better than others -- and the circumstances of each portfolio company will have an effect. “There will certainly be some differentiation that we’ll see in asset quality performance across BDC portfolios and I’d say their approach to utilizing PIKs or other amendments will probably play into that,” said Richardson.
Earnings on Deck
Private credit market participants will be watching for further PIK-related income when BDCs begin reporting quarterly earnings next week. This comes as a handful of companies have been selling PIK notes in the junk bond market recently to finance dividend payments to their private equity owners.
Most BDC borrowers that have recently deployed the PIK structure have come from sectors that have been hammered by Covid-19. In August, lenders hiked the interest rate on a loan to Mindbody Inc., which makes software used by gyms and spas, and switched a portion of the debt to be paid in kind. Another private lender tweaked interest on debt to restaurant chain Rosa Mexicano Co. to mostly be paid in kind.
A representative for Owl Rock Capital Corp., a BDC lender to Mindbody, declined to comment. Emails seeking comment from Prospect Capital Corp., a BDC lender to Rosa Mexicano, weren’t immediately returned.
More Pain
Analysts at Jefferies have flagged that they’re cautiously optimistic about BDCs and that credit has held up better than many feared early on in the pandemic. The firm said large BDCs that are well-capitalized, have a handle on leverage and liquidity will be best positioned to ride out the crisis.
Overall, though, BDCs are likely in store for more pain in its credit portfolios as the pandemic stretches on. So far this year, the benchmark BDC index has lost roughly 25% as the coronavirus pandemic has injected uncertainty in the market.
In an August report previewing upcoming concerns for BDCs, Raymond James analysts Robert Dodd and Matthew Tjaden wrote that PIK income can be a “forward indicator of non-accruals” -- or soured loans. The analysts said they see no reason nonpayments will fare better in this downturn than the Great Financial Crisis, due to weaker loan documents and higher levels of earnings adjustments.
Fitch said more time is needed to assess the impact of recent amendments on BDC portfolios. The credit grader slashed its outlook for the sector ahead of likely deteriorating credit performance.
©2020 Bloomberg L.P.
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