The PIK Divide: Separating Structural Flexibility from Shadow Distress in Private Credit

As of the first quarter of 2025, 11 percent of debt investments tracked by Lincoln International carried some form of payment-in-kind interest — a figure that had climbed from 7 percent in the fourth quarter of 2021.¹ The headline share, while notable, conceals a sharper distinction. Lincoln’s data shows that 6 percent of all tracked deals now carry what practitioners have taken to calling “bad PIK” — loans that had no PIK provision at origination but were subsequently amended to permit interest capitalization, up from just 2 percent at end-2021.¹ Lincoln’s analysts note that loan-to-value ratios on these amended credits rose from 49 percent at the time of investment closing to 86 percent by the first quarter of 2025, a deterioration that underscores the economic stress driving the amendments rather than any deliberate underwriting choice.¹

The remaining PIK exposure in the market represents “good PIK” — structures where payment-in-kind was a deliberate feature at origination, typically in mezzanine, growth capital or more complex sponsor transactions where cash flow preservation was an intended element of the financing. The economic logic of structural PIK is well-established: it aligns debt service with business maturation, preserves borrower cash for reinvestment, and compensates lenders through compounding accruals at higher all-in yield rates. From the outside — an LP report, a BDC filing, a trustee statement — the two forms of PIK are often indistinguishable without granular disclosure.

What distinguishes them, according to a 2025 academic study drawing on comprehensive Business Development Company loan data, is the point in the loan’s life at which PIK appears. Research by Paul Rintamäki and Sascha Steffen of the Frankfurt School of Finance and Management, posted to SSRN in July 2025, found that PIK is primarily used for forbearance, that it concentrates among distressed firms, and that it predicts persistent credit deterioration rather than recovery.² Critically, the study found that adverse outcomes are driven specifically by PIK exercised after origination, not PIK structured at closing. Where private equity sponsorship is present, outcomes are partially better, consistent with the expectation that sponsors provide capital support alongside PIK concessions. The paper further found that funding markets impose a degree of discipline on excessive PIK-lending by BDCs: bank lenders reduce funding to BDCs with elevated post-origination PIK exposure, and public equity investors discount BDC shares that carry higher concentrations of amendment-driven PIK.²

### Why Bad PIK Is Rising Now

The current accumulation of involuntary PIK amendments traces to the interest rate cycle in a direct and mechanical way. Companies that took on floating-rate leveraged loans in 2021 and 2022, when SOFR was near zero, have watched their cash interest burdens increase by several hundred basis points as the base rate rose. A borrower carrying a spread of 600 basis points that closed when SOFR was below 1 percent faces a materially higher cash interest obligation at SOFR levels above 4 percent. For companies with high leverage ratios, the additional burden can consume a substantial share of free cash flow, leaving inadequate room for capital expenditures, working capital cycles or operational investments.

Faced with borrowers that cannot maintain cash interest service, lenders confront a structural incentive problem. Declaring a payment default triggers acceleration rights and forces a formal restructuring process that would crystallize losses on positions currently carried near par. Amending the credit agreement to permit PIK interest preserves the par mark, maintains the loan’s performing status and defers the recognition of stress. For BDC managers whose net asset values, fee income and incentive compensation are tied to portfolio marks, the economic logic of PIK amendments is apparent.

The incentive to defer through PIK rather than recognize stress through formal default is reinforced by the structure of private credit reporting. Reported default rates for private credit remain lower than rates for broadly syndicated loans and public high-yield bonds. KBRA’s Middle Market Default Monitor, which consolidates borrowers in payment default or assessed as likely to default absent ongoing lender concessions, stood at 2.1 percent by value of assessed notional debt outstanding as of the third quarter of 2025 — below comparable default rates in the broadly syndicated market.³ KBRA noted in that same publication that it expected the default monitor to begin rising in 2026 as credit fundamentals weakened among certain segments of the middle market.

### Structural PIK Versus Amendment PIK: How Lenders Draw the Line

The Golub Capital white paper “The Bigger PIK-ture,” published in late 2025, provides a practitioner framework for distinguishing these categories.⁴ The paper identifies three structural forms: PIK structured at origination as a deliberate feature for a fundamentally healthy borrower; PIK toggle provisions that allow borrowers to switch between cash and in-kind payments, typically built into agreements for larger borrowers competing with the broadly syndicated market; and mid-life PIK amendments that introduce or materially increase PIK spread post-closing.

The significance of the latter category is material. Drawing on a review of over 300 private credit agreements executed in 2024 by S&P Global, Golub Capital’s white paper reports that 41 percent of large-market direct lending deals — those with loan sizes above $750 million — included a PIK toggle feature at origination, compared to just 7 percent of middle-market deals with loan sizes below $750 million.⁴ This gap reflects the competitive dynamic at the upper end of the market, where private direct lenders use PIK toggle provisions to attract borrowers who might otherwise access the public leveraged loan market. In the middle market, PIK at origination is far less common, which means a higher share of PIK exposure in middle-market portfolios is attributable to amendments rather than structural design — a distinction that matters for credit quality assessment.

The Golub Capital paper also identifies what it terms “materially modified PIK,” defined as amendments where the PIK spread increases by 250 basis points or more post-origination. This category began rising in late 2022, lagging the Federal Reserve’s rate hiking cycle by roughly six months, and has continued to grow. The paper found that structural PIK and materially modified PIK have contributed roughly equally to the overall rise in PIK over the past four years, indicating that the market’s PIK expansion is not simply the product of competitive deal structuring but reflects a meaningful component of reactive borrower accommodation.⁴

### The Shadow Default Rate Question

For institutional allocators, the distinction between structural and amendment-driven PIK raises questions about the reliability of private credit’s reported performance metrics. If PIK amendments to borrowers that would otherwise be in payment default are treated as a form of forbearance equivalent to a functional default, the true stress rate across the asset class is higher than headline default monitors suggest. Lincoln International’s data implies this: the 6 percent “bad PIK” share in its Q1 2025 data, which Lincoln explicitly characterizes as a potential “shadow default rate,” is notably higher than KBRA’s 2.1 percent formal default monitor reading for the same period.¹³

PGIM’s direct lending team has flagged this dynamic as warranting close scrutiny from investors. In a 2025 video commentary, PGIM’s direct lending professionals noted that higher base rates have weighed on heavily leveraged companies, that many now face interest payments exceeding cash flow, and that PIK loans have become a popular mechanism for addressing short-term liquidity issues — but that the concealed risks of PIK can outweigh the apparent yield enhancement it offers.⁵

The accumulation of amendment-driven PIK also has implications for leverage facilities extended to BDCs and private credit funds. Subscription lines, NAV facilities and warehouse structures are typically sized based on portfolio quality metrics. If PIK-related deterioration is not captured in those metrics — because the loans remain technically performing — facilities may be extended against portfolios carrying greater embedded credit risk than the documentation reflects. The Rintamäki-Steffen research is consistent with this concern: it found that bank lenders do in fact reduce funding to BDCs with elevated post-origination PIK exposure, suggesting that at least some capital markets participants are already pricing this risk, even if fund-level reporting does not always make the distinction explicit.²

### What LP Due Diligence Should Ask

Across public BDC disclosures, PIK income as a share of total investment income has risen across the sector over the past several years. The composition of that income — how much derives from structural origination PIK versus amendment-driven forbearance PIK — varies widely across managers and is not uniformly disclosed in standard financial statement formats.

For limited partners conducting diligence on private credit fund managers, the Rintamäki-Steffen academic findings, the Lincoln International shadow default rate framing, and the Golub Capital framework all point toward a consistent set of questions: What share of PIK exposure in the portfolio was structured at origination versus introduced through amendment? For amendment-driven PIK positions, what concessions did the lender receive alongside the PIK accommodation? What are the leverage and coverage ratios of PIK-bearing credits relative to the portfolio mean? And has the share of amendment-driven PIK grown, stabilized or declined over the trailing year?

The answers to these questions will not appear in a standard tear sheet or a quarterly update letter that reports aggregate PIK income as a percentage of total investment income. They require portfolio-level transparency that the best-managed direct lending platforms provide to their LPs but that remains inconsistent across the market. The Golub Capital framework notes that PIK at origination, when tied to a fundamentally sound business, can be a risk-adjusted feature supporting long-term value creation; the same feature introduced reactively to address deteriorating fundamentals presents a different risk profile entirely.⁴

### Conclusion

Payment-in-kind interest is not inherently a sign of distress. It is a structuring tool with legitimate applications across the capital structure, and the academic and practitioner literature is consistent on this point: context, timing and the circumstances of PIK implementation determine what the feature signals about a borrower’s condition. What the current data makes clear is that the composition of PIK exposure across private credit portfolios has shifted over the past several years. The share attributable to amendment-driven forbearance has risen materially, even as structural origination PIK has also grown in competitive deal markets.

Lincoln International’s characterization of its 6 percent “bad PIK” share as a potential shadow default rate is the most direct statement yet from a valuation-level data source that reported performance metrics in private credit may understate true credit stress.¹ The KBRA default monitor, reading 2.1 percent of notional value in default as of the third quarter of 2025, and the shadow rate implied by Lincoln’s data are not necessarily in conflict — they measure different things — but the gap between them is the territory where the real underwriting challenge of the current cycle lives.³ Lenders, LPs and analysts who understand that gap, and who can classify PIK exposure accordingly, will have a materially more accurate picture of portfolio health than those who treat a single PIK percentage as a sufficient summary statistic.

The middle market, where information asymmetry is greatest and secondary market discipline weakest, faces the sharpest version of this challenge. As the Rintamäki-Steffen research confirms, funding markets do eventually impose discipline on BDCs that allow post-origination PIK to accumulate without adequate compensation — but that discipline arrives with a lag.² Lenders that build and disclose rigorous PIK classification systems, and LPs that conduct granular diligence on PIK composition rather than accepting aggregate PIK-income percentages as a proxy, are better positioned to navigate the current environment than those who allow the distinction between structural flexibility and shadow distress to remain blurred.

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Footnotes

1. Lincoln International — “While the Lincoln Private Market Index Grew in Q1, Negative Trends are Brewing,” May 22, 2025 (11% of tracked investments had PIK as of Q1 2025, up from 7% in Q4 2021; 6% of all deals had “bad PIK” in Q1 2025, up from 2% in Q4 2021; LTV on bad PIK loans increased from 49% at close to 86% in Q1 2025; Lincoln characterizes this as a potential “shadow default rate.”)
2. Rintamäki, Paul and Steffen, Sascha — “When Flexibility Becomes Forbearance: Payment-in-Kind in Private Credit,” July 6, 2025, Frankfurt School of Finance & Management (PIK primarily used for forbearance; concentrated among distressed firms; predicts persistent deterioration; adverse outcomes driven by post-origination PIK; bank funding decreases with BDC PIK exposure; equity investors discount post-origination PIK.)
3. KBRA — “Private Credit: Q3 2025 Middle Market Borrower Surveillance Compendium: Defaults Will Rise,” November 25, 2025 (KBRA Middle Market Default Monitor by value = 2.1% of assessed notional debt outstanding as of LTM Q3 2025; KBRA expected default monitor to rise in 2026.)
4. Golub Capital — “The Bigger PIK-ture: Bringing Clarity to Payment-in-Kind Structures in Private Credit,” January 2026 (data as of December 31, 2024) (41% of large-market deals >$750M included PIK toggle at origination vs. 7% of middle-market deals <$750M, per S&P Global review of 304 credit agreements executed in 2024; materially modified PIK began rising in late 2022; structural and materially modified PIK have contributed roughly equally to PIK growth over four years.)

5. PGIM — “Inside Private Credit: Understanding Payment-in-Kind,” November 4, 2025 (Higher base rates have weighed on heavily leveraged companies; PIK has become a popular mechanism for short-term liquidity issues; concealed risks can outweigh potential yield re