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Synthetic PIK: The Latest in Financial Innovation

In recent months, some private credit firms have begun pitching a new arrangement marketed as a synthetic payment-in-kind (PIK) note.

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Traditional PIK structures, which allow borrowers to defer cash interest payments by adding to the principal balance, have been a go-to offering for private credit and one of its differentiators in the competition to beat out less flexible broadly syndicated offerings from banks. However, funds often face limitations to their PIK lending imposed by their own debt financing sources.

The synthetic structure is a novel way to sidestep these constraints while achieving a similar economic outcome. In practice, it’s not much different for the borrower than a traditional PIK note — rather than a private equity-led innovation, the emergence of the synthetic PIK is largely a function of private credit creativity.

Mechanically, the synthetic structure involves two separate debt facilities: the primary loan and an accompanying delayed-draw term loan (DDTL), also known as the synthetic interest payment facility (SIPF).

When interest payments are due on the primary facility, the borrower draws on the DDTL (the SIPF) and uses those proceeds to make the primary facility cash interest payment.

The incremental outstanding principal for that interest payment then accrues to the DDTL rather than the primary loan, as would be the case in a typical PIK. This arrangement allows the borrower to defer the actual cash outlay, as they would in a traditional PIK structure, while technically maintaining cash interest payments.

For private credit firms, the synthetic PIK lets them offer flexibility to borrowers without the risk of running afoul of PIK exposure limits set by their own lenders — typically imposed at the portfolio level to maintain the quality of the collateral pool backing the private credit fund's borrowings.

The exact terms of these synthetic PIK deals can vary significantly. In some cases, only a portion of the interest may be funded through the DDTL. The pricing, fee arrangements, and other terms of the DDTL may also differ from the primary facility.

The structure has received some criticism over its potential to mask the true health of private credit funds and their underlying assets. Traditional PIK loans can be riskier as repayment is delayed relative to a cash-pay loan. Because of that, some critics argue that private credit valuations for PIK facilities should be marked meaningfully lower than they are.

With a general uptick in the scrutiny of private credit valuations, the synthetic PIK development adds fuel to the fire in two primary ways: (1) A greater percentage of the portfolio can now be comprised of potentially riskier PIK assets, which in turn can obfuscate trouble within the portfolio and even keep valuations at par for credits which would otherwise be non-performing; and (2), synthetic PIK arrangements may even mask the true extent of PIK debt within a lender’s portfolio, beyond just skirting around financing restrictions.

On the second point, third-party valuation firms (typically employed by the fund itself) may not always have full visibility or awareness of instances in which synthetic PIKs are in play. From their perspective, the arrangement may just appear to be a traditional cash-interest loan to a borrower who happens to also be drawing on their DDTL.

Sam Hillier

Sam Hillier is a reporter at Transacted covering private equity and investment banking. He previously spent time as an investment professional focused on middle market buyouts.