Private equity managers are increasingly turning to payment-in-kind structures to ease pressure on portfolio companies, but a lack of systems capable of modelling their complex impact could create growing operational and transparency risks, a new study by Occorian has found.
Some 86% of private equity fund managers surveyed expect the use of PIK structures within their private credit exposure to increase over the next two years, according to research by the asset services provider.
The survey covered private equity managers in the US and Europe overseeing a combined $3.511tn in assets. Of those expecting greater use of PIK, 4% anticipate a significant increase, while 82% expect a more modest rise.
PIK structures allow borrowers to defer cash interest payments by issuing additional debt or equity to lenders. The mechanism can provide portfolio companies with greater flexibility during periods of elevated borrowing costs, but can also increase leverage and make it more difficult to assess the underlying financial health of a business.
Nine out of 10 respondents said they believed there was a growing risk that increased use of PIK could mask genuine borrower distress. Some 16% strongly agreed that the deferral of cash obligations made it harder to distinguish between proactive capital management and serious liquidity problems.
“Private equity fund managers are doing everything they can to support portfolio companies through a prolonged period of higher financing costs. However, this flexibility does come with a warning label,” said Anatoly Sorin, UK head of loan agency and bond trustee services at Ocorian.
The growing use of PIK structures is also creating challenges for private equity firms’ internal systems and fund administration processes.
As PIK interest compounds, it can affect preferred return hurdles, distribution waterfalls and the calculation of realised and unrealised gains — metrics that are ultimately used to determine performance fees and carried interest.
Only 17% of respondents said they had robust automated systems capable of fully incorporating the impact of compounding PIK interest into waterfall calculations.
A further 39% said they could model PIK structures but required significant manual adjustments, while 32% relied entirely on external providers such as fund administrators to handle the complexity.
Another 10% said PIK modelling remained a gap in their current capabilities, while 2% said the exposure was not yet material enough to justify dedicated systems.
“With PIK structures becoming more prevalent, firms’ operational and technological capabilities must keep pace, either in-house or by outsourcing to expert third-party fund administrators,” Sorin said.
The increasing reliance on PIK also places greater emphasis on governance and oversight, according to Abi Reilly, partner for regulatory and compliance at Ocorian.
Firms need to be able to demonstrate how PIK structures are monitored, modelled and reported, particularly as complexity increases and more of the work is delegated to external service providers, she said.
The findings come as private equity managers face continued pressure to support companies through higher interest rates and challenging refinancing conditions. While PIK structures can help preserve cash within portfolio companies, their growing use may also postpone rather than resolve underlying financial stress.
For the private equity industry, the challenge will be ensuring that greater flexibility in financing structures does not come at the expense of transparency around leverage, portfolio company performance and the eventual returns available to investors.
