By Bill Alpert

A surprising share of income at big private credit funds comes from borrowers who pay their interest with IOUs, instead of cash.

At the biggest fund, the $30 billion Ares Capital Corp., 15% of December quarter income came from noncash interest, according to a Thursday analysis by Robert Dodd, at Raymond James. At the $14 billion FS KKR Capital, it was 16%. And at the $6.5 billion Prospect Capital Corp., it was 9%.

These IOUs get added to the borrower's loan balance, and are known in the trade as "payment-in-kind," or PIK. Lenders are willing to wait, because they charge PIK borrowers at higher interest rates. But investors don't like it, because they suspect the borrowers have cash flow problems.

Loans with PIK interest became a bigger part of fund portfolios in the last two years, after the Federal Reserve's rate hikes. At the end of December, PIK loans were 17% of fund assets, on average.

"Overall PIK remains elevated," Dodd says. "PIK asset exposure remains roughly within the same range it has hovered in for the last two years."

Credit fund stocks have sunk below their portfolios' net asset values, because investors believe that hidden loan problems make them worth less than what they're valued on the books. Ares Capital trades for 90% of its net asset value, FS KKR trades at 48%, and Prospect at just 41%.

Ares stock suffers less of a discount, even though it got more of its profit from PIK than the other two funds. There are several reasons for that, but one is that there are different kinds of PIK.

Since 2023, the credit funds have competed for customers by structuring loans to allow some noncash interest for the first few years. These planned PIK terms can actually boost the lender's profit and they don't normally trigger alarms.

It's unplanned PIK that is a worry, when a borrower is struggling and the lender changes the loan terms to allow noncash interest and prevent the loan from showing up as a default. Dodd worries when he sees loans go from cash to PIK interest and where the PIK interest rate is more than four percentage points higher than the original cash rate. He says that such "materially modified" loans are 10 times more likely to default, than a cash loan.

Some funds have more of these materially modified PIK loans than do others. By Dodd's count, they make up more than 20% of Prospect's portfolio. They're about 5% of FS KKR's, and just 1% or 2% at Ares. Most of Ares's PIK loans were planned.

Another insight into Ares's PIK loans emerges from its cash flow statements. It shows that more than half the income described as PIK interest on December's income statement was actually received as cash. That's because many loans with PIK terms get paid in cash, during a quarter. So PIK income at Ares isn't really as high as its income statement shows.

So not all PIK is bad PIK.

Write to Bill Alpert at william.alpert@barrons.com

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March 26, 2026 17:36 ET (21:36 GMT)

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