Are Risks Rising for Prospect Capital Corporation and Ares Capital Corporation?

Photo: Håkan Dahlstrom.

A riskier form of financing is exploding in the middle market -- payment-in-kind securities, also known as PIK securities, are becoming a "new normal." PIK debt allows a business to defer interest for years, adding it to the outstanding balance and compounding a company's indebtedness.

Should investors in middle-market business development companies like Prospect Capital (PSEC 0.18%) and Ares Capital (ARCC -0.12%) start to worry?

PIK explained
PIK securities are unique in that the borrower does not need to make interest payments in cash. Instead, interest is typically added to the balance of the loan. Thus, if a company borrows $10 million at 10% with interest paid-in-kind, by next year it would owe $11 million. The interest would continue to compound until the loan came due, presumably years down the road.

You can see how this could get problematic. Over time, interest that is rolled into the loan results in a larger and larger balance due. When the debt finally matures, the company is on the hook for much more than they originally borrowed.

Private equity is turning to PIK debt
PIK issues typically follow more aggressive lending practices as investors hunt for yield. Recently, two large private equity-backed companies, Michael Baker and BMC Software raised $125 million, and $750 million, respectively, in PIK debt to cash out their private equity sponsors.

If this isn't evidence for yield hunting, I'm not sure what is. Not only did private-equity sponsors cash out their equity stakes by raising debt (and thus increasing leverage), they did it with perhaps the most risky of debt issues.

I went back through the previous filings for Prospect Capital and Ares Capital -- two of the largest publicly traded players in middle-market lending -- to measure their involvement in PIK lending. Using data from Dec. 31, 2013, I was able to construct this table for PIK exposure.

It's important to note that this table includes all securities with a PIK component. Thus, if any loan has any PIK component whatsoever -- even a fraction of the interest due -- it is included in the table.

All else being equal, it's safe to say that risk goes up with the percentage of debt investments that contain a PIK component. The fact is that there is a reason the borrower wanted looser repayment terms -- perhaps because it couldn't immediately afford to expend cash to pay its debts.

For example, Ares Capital's portfolio investment, Gilchrist & Soames, borrowed $22.5 million at 15.44% interest. Because 2% of the stated interest rate can be paid-in-kind, the entirety of the loan at cost and fair value is included in the table.

I'm writing this article, and tracking the data, because it appears that PIK debt is becoming increasingly common in the middle market. When Ares and Prospect Capital file their first calendar quarter earnings, their PIK exposure will serve as a proxy for the increasing levels of PIK debt issues in the middle market.

Given Prospect Capital and Ares Capital finance the largest of middle market companies, frothiness would likely first appear in their portfolios. We'll see how this develops when they file their new portfolio compositions with the SEC later in May.