PIK toggle flexibility becoming increasingly important for borrowers as direct lending funds seek to differentiate

As central banks raised rates throughout 2022 and 2023, the limiting factor in debt structures increasingly became cash cover rather than leverage. What might have remained a comfortable debt/cap % likely meant a debt service challenge that neither lender nor borrower were comfortable with. While less leverage is always one answer, taking a longer term view on both interest rates and the future performance of a credit has driven an increase in an element of margin being roll-up through PIK. Funds raised in lower rate environments have the flexibility to defer some of their return, including scope to PIK higher proportions in the early stages (12-24 months) of a deal. Furthermore, for larger transactions that are now benefiting from the re-opening of the tighter-priced capital markets, PIK-toggles give debt funds a competitive feature in efforts to protect their market share.

For older deals with all cash-pay structures where the majority of borrowers are unhedged, debt service has come under increasing pressure. Here, the same principle applies where, for strong credits, lenders are prepared to amend structures to accommodate an element of PIK to relieve that pressure to the benefit of all.

Alantra Debt Advisory have noted a favourable shift for borrowers in respect of funds’ willingness to accommodate greater PIK toggle flexibility.