Payment-in-Kind in Private Credit: Liquidity Tool or Early Signal of Stress?

Payment-in-kind (PIK) interest has moved from a marginal feature of private credit documentation to a central indicator of borrower stress and portfolio risk. In its conventional form, PIK allows a borrower to capitalize interest rather than pay it in cash, increasing the principal balance of the loan. For first lien senior secured lenders, this is rarely the preferred outcome. Cash interest provides immediate income and liquidity; PIK accrual defers both. The recent increase in PIK usage therefore warrants close attention, not as a technical footnote, but as a meaningful signal about credit conditions beneath the surface of reported default data.

The primary catalyst has been the rapid normalization of short-term interest rates. Middle market loans are typically structured as floating-rate instruments priced at a spread over SOFR. As SOFR rose from near zero to multi-year highs, cash coupons increased sharply while leverage levels remained largely unchanged. The mechanical effect on borrower interest burden has been significant.

As illustrated, a borrower carrying 4.6x leverage on stable EBITDA saw interest expense rise from roughly 25% of EBITDA to 45% solely due to higher base rates, despite unchanged spreads and operating performance. Many capital structures built during the low-rate era were not designed for this level of sustained interest coverage compression. In that context, PIK has become a liquidity management tool, enabling borrowers to preserve cash for operations or restructuring initiatives.

At origination, PIK is uncommon in first lien structures. Its introduction midstream is more consequential. Data from Lincoln International highlights a steady increase in the proportion of private credit investments incorporating PIK features.

By Q1 2025, 10.7% of investments included some PIK component, up from 6.8% in 2021. The more instructive detail, however, is not the aggregate share, but the migration within the portfolio. A majority of these PIK-bearing investments did not include PIK at underwriting; the feature was added through amendment.

This distinction between original PIK and amended PIK is critical. Loans that were structured with PIK from inception often reflect anticipated growth curves or deliberate capital structure design. By contrast, “bad PIK” — where PIK is introduced unexpectedly — typically reflects emerging cash flow strain.

The expansion of amended PIK is less about structural design and more about credit migration. Debt associated with investments that did not include PIK at underwriting but now do has expanded from $1.5 billion in Q4 2021 to $36.1 billion by Q4 2025. Over the same period, the share of such investments rose from 35.5% to 58.3%. This is not a structural feature of new deal design; it reflects a post-closing shift in payment mechanics. In practical terms, a growing portion of the market has required modification of originally agreed cash interest terms.

That progression underpins the concept of a “shadow default rate.” When 58.3% of PIK-bearing investments were amended into PIK status rather than structured that way at origination, the economic signal differs from a deliberately underwritten PIK feature. These amendments represent borrowers unable to sustain prior cash interest burdens under prevailing rate and earnings conditions. Because such modifications typically occur through negotiated amendments rather than formal payment failures, they do not register in traditional default statistics. The result is a widening gap between reported defaults and economically stressed credits operating under revised terms.

The proportion of transactions classified as “bad PIK” increased from roughly 2.5% in 2021 to approximately 6.5% in 2025, suggesting that the effective stress rate within private credit portfolios exceeds reported rating agency default figures. This divergence does not, in itself, imply systemic instability. The private credit model is designed to facilitate negotiated amendments and liquidity solutions prior to formal acceleration. However, when cash interest obligations are restructured into PIK midstream, the economic substance resembles a distressed modification. Such credits may remain outside official default statistics, yet they represent borrowers operating under revised and weaker payment terms.

Importantly, the rise in PIK has occurred alongside changes in market pricing. As more capital has entered private credit, spreads over SOFR have compressed, and all-in yields have declined from peak levels. In a competitive environment where borrowers can negotiate tighter pricing, lenders may be more inclined to utilize PIK amendments rather than pursue enforcement actions that crystallize losses. The trade-off is that principal balances increase while underlying EBITDA growth moderates. Lincoln’s data indicate that the proportion of high-growth issuers has declined, and average EBITDA growth has slowed. At the same time, leverage has edged higher rather than declining through amortization.

For Business Development Companies (BDCs), the implications are particularly acute. BDCs are required to distribute the vast majority of taxable income as cash dividends. Because taxable income includes both cash and PIK interest, a rising share of PIK income can create a liquidity mismatch. If cash receipts fall short of reported income, BDCs may need to access capital markets to fund distributions, potentially through dilutive equity issuance or incremental leverage within regulatory constraints. Sustained growth in PIK income therefore has direct consequences for capital management and shareholder returns.

None of this suggests that PIK is inherently problematic. It can serve as a pragmatic bridge for borrowers facing temporary dislocation, preserve enterprise value by avoiding liquidity-driven disruption, and enhance lender positioning in a restructuring. However, the aggregate trend matters. When PIK usage rises in tandem with slower EBITDA growth, compressed yields, and stable or increasing leverage, it signals that credit risk may be migrating rather than dissipating.

For institutional investors, the appropriate response is analytical rather than alarmist. Portfolio monitoring should differentiate between structural PIK at underwriting and amended PIK introduced under stress. Tracking the proportion of investments transitioning into PIK status provides insight into borrower health that conventional default metrics may obscure. In the current environment, PIK is not simply an income feature; it is an embedded indicator of liquidity pressure and evolving credit quality within the private credit market.

Sources & References

Fortune. (2026). In the $3 trillion private credit market, the ‘shadow default’ rate is increasing as more money chases lower-quality deals. https://fortune.com/2026/02/22/private-credit-market-shadow-default-rate-deals/ 

TCW. (2025). The Big PIK-ture. https://www.tcw.com/Insights/2025/2025-08-18-The-Big-PIK-ture