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Private Credit 

Emily Fasold

Sasha Padbidri

David Bell

As competition between underwriters ramps up and borrowers grapple with tightening free cash flow amid high interest rates, some direct lenders are offering a tool that many debt investors have shied away from in the past — payment-in-kind coupons.

Often associated with highly levered capital structures and risky holdco debt, PIK coupons allow borrowers to pay coupons with additional debt rather than cash. They’re not a new phenomenon, but a notable recent example in the private credit space has thrust them into the spotlight.

Healthcare technology firm Cotiviti, which has been entertaining financing offers from traditional underwriters and private credit firms for its acquisition by Carlyle, is reportedly in talks with direct lenders for a $5.5bn loan that would include a generous PIK feature. 

If completed, the deal could end up being the biggest unitranche loan ever seen. And the principal could get bigger still, because the PIK feature would allow the company to pay 50% of the loan’s interest with additional debt for up to two years.

As such, this loan — which is being offered by a lenders including Apollo Global Management, Blackstone and HPS — could be something of a watershed moment for private credit. At the very least, it’s a mark of how far the jumbo unitranche market has come since early deals like Qlik.

In the competitive Cotiviti process, the PIK option appears to have helped private credit fend off competition from traditional leveraged finance bankers, who are generally less willing to offer such a structure. Indeed, in conversations with us and on social media, some broadly syndicated investors have suggested these funds may have overstepped the mark.

“PIKing a material amount on a deal straight out of the gates in this environment is God’s way of saying we’ve gone too far,” one CLO manager said. “If you have to pray that something works based on the structure, you might want to check yourself.”

However, some sources familiar with the Cotiviti unitranche told us the PIK feature was at least partially driven by the interest-rate environment, as opposed to purely by a competitive financing process. 

One suggested that the PIK coupon was a way to make the deal work at a more aggressive leverage ratio, noting that Cotiviti was a well-regarded credit. 

“High-quality companies are continuing to trade at valuation multiples from a year ago, but the rate environment today is very different,” said the head of private credit at a large PE firm. “So either you lend at the same leverage and find ways to enhance cashflow, or you lower the overall debt.”

With SOFR currently at 4.5% and showing no signs of falling (although some prognosticators have suggested the recent collapse of Silicon Valley Bank could force the Fed to cut rates) lenders are under increasing pressure to help borrowers handle higher interest costs, said another private credit source. 

“Companies can’t handle even more interest payments, so its a logical part of the game at this point,” the source said. “If rates stay higher, which they will, existing deals won’t be able to get done without some sort of rate ratchet. It’s just folks getting creative.”

Not everyone takes the view that PIK coupons are an appropriate solution to higher rates. 

One direct lender we spoke to for this piece said they had a very simple rule: “We’ve taken the stance that if a company can’t afford to pay the debt in cash, then its too much debt.” 

Another suggested that using a PIK option to offset the cashflow impact of higher coupons “goes against leveraged finance principles”. But that source, who focuses on the European private credit market, said there can be exceptions for companies with genuine business needs. 

“In our first-lien deals we often allow PIK toggles for 50% of the margin, but we have looked at deals where we would PIK the whole margin,” they said. “Let’s say they have a big capex program coming up, or some other business reason for wanting to preserve cash flow.”

As a unitranche loan, Cotiviti’s deal blends the senior and subordinated debt into one piece. That could be seen to offer lenders some comfort compared to a classic holdco PIK toggle, and on top of that, the borrower will pay a hefty price for the PIK option.

According to Bloomberg’s reporting, if the company opts for the PIK component, its margin will increase to 7% over the benchmark from the cash rate of 6.25%. 

In a recent interview with 9fin, Michael Patterson, who leads the direct lending platform at HPS — which is part of the lender group proposing the loan — said Cotiviti was a strong credit and deserved the flexibility offered by the PIK. 

“We think Cotiviti is a really attractive value risk proposition for both sides,” he said. “Its a great company and when you dive into their business plan, you can see that they aren’t just negotiating for sport. They earned this flexibility, and they’ll also pay a premium for that flexibility.”

The large equity cushion also helps. Some sources noted Cotiviti’s high loan-to-value ratio and its ability to scale quickly, which have helped it become a well-regarded credit and a strong PIK candidate.

“There’s not enough interest coverage right now and this is a reflection of that, but Cotiviti is an extremely prime asset, which is why folks were comfortable offering a PIK” said a second CLO manager. 

For more on interest coverage, check out our recent feature on how this “old-school” credit metric is coming back into fashion.

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