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Payback Lower for Many Pay-Later Loans
Direct Lending bad-PIK has become a problem; borrowers falling behind plan, debt service <1x. Solution: defer the interest payments, just add it to principal owed. BUT, leverage climbs exactly when the business is weakest. PIK currently runs >11% of BDC portfolios with 55.4% classified as Bad-PIK (i.e. PIK not part of the original terms).
Consumer credit BNPL to subprime borrowers is the consumer version of bad-PIK although technically the BNPLs are originated at discounts to par to support the economics as they are originally as the high implied interest charged is built into the discount. BNPL receivables self-liquidate in six weeks, as the exposure ultimately consolidates at the household level: a subprime borrower borrowing across multiple lenders that don't see each other.
The aggregate position is too highly leveraged, with debt adding up as time rolls along. A FICO score below 620 is the consumer equivalent of a CCC corporate credit, and roughly 60% of U.S. BNPL borrowers sit in subprime or near subprime.
About 41% report paying late. The consumer is spending beyond current income, late fees and rollovers push the implied rate well into distressed levels, and repayment is deferred to a future. While the reported 'defualt rate' is low for BNPL, a rising percentage of BNPL are falling further behind on their payments. While the mechanics for BNPL are not similar to bad-PIK toggle, both relate to weaker credits made outside of the banking system by the private sector.
Allowing lower-rated companies that do not have cash flow to service its debt or, alternatively, lending to stretched subprime consumers whom have taken on too much additional debt usually result in higher default rates any way you stack it. PLPL (pay-late, payback-lower).
Takeaway #1: Lend to companies and consumers whose cash flow can comfortably service the debt and ultimately repay principal or lend against hard collateral where you hold a perfected security interest and a real margin of safety (LTV).
Takeaway #2: PIK at close, structured for growth companies have a completely different IRR/MOIC profile vs. Bad-PIK.
Takeaway #3: Rates will be higher for longer as the Fed has begun to tighten, allowing lenders to be paid handsomely. It continues to be a great time to invest to be a private and public credit investor.
Takeaway #4: With interest rates higher, interest expense/debt service will be impactful for a greater percentage of private credit issuers who may fall below the critical 1x debt service coverage ratio; thus bad-PIK ratio may increase in the coming months.
Takeaway #5: The K-shaped economy is alive and well; while corporate earnings grow, the economy thrives, over-levered/weaker companies struggle as rates rise.
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