How Many Grains of Sand in a Pile?
2025 has been filled with multiple news stories downplaying ‘small’ private credit implosions and celebrations of the genius that AI brings to the US marketplace. While there were multiple little [$100-$200M] blowups that impacted major banks such as JP Morgan, Barclays and Fifth Third, there are three headline stories that kicked the first domino, in what I believe is the start of the end of the PC mirage. July brough Tricolor’s liquidation due to $1.2B of systematic double pledging. Was bundling subprime auto loans marketed specifically to immigrants in the largest deportation event in US history a sound business decision? No – but Tricolor lacked internal controls to catch nearly 30,000 subprime loans tied to vehicles securing other debts. September brought First Brands collapse, exposing $2.3B in factored auto-parts receivables that “simply vanished.” Most recently, we find Blackrock’s PC arm and HPS Investment Partners tied up with Bankim Brahmbhatt in $500M in receivables that were fabricated. Ironic, considering Blackrock purchased HPS for their ‘expertise.’ Expertise in lending into a black hole, perhaps? Are these the strong foundations and covenants promised through the $1.7T boom of the private lending sector? The job of credit due diligence is trust but verify; they seem to have doubled down on the first part and forgotten about the second part. When appetites are high sometimes doing the deal becomes more important than the deal that gets done. Participants lack end-to-end visibility and invest hoping no one manipulates the collateral. We are learning that receivables based lending and multi-tiered financing chains create opacity at every intersection. The insatiable risk appetite leading up to the Great Financial Crisis [GFC] was securitization creating sex appeal out of credit hot potato. Questions like, “Will the borrower pay back this mortgage?” or, “Do they have any income or assets?, became totally irrelevant. Lend the money, package it up, sell it, and don’t worry about the rest…financial innovation solved the problem. Could this be the New Century or Countrywide of 2006/2007 – the tip of the iceberg of GFC?
It’s Better Than Money…It’s an IOU
Payment in Kind [PIK] is that magical loan feature where the lender says, “Oh, you can’t pay interest right now? No worries, we’ll just slap it onto the tab and deal with it later.” In normal healthy markets, PIK can be a strategic tool –conserving cash, funding capex, bridging gaps or keeping those pesky liquidity and leverage ratios looking respectable. But what we’re seeing now? A full-on PIK party across the entire PC industry. And let’s be honest, that’s usually code for “our borrowers are running low on actual cash,” or “operating cash flow? Never heard of her.” Sure, you could call it an industry-wide appetite for more risk; an adrenaline rush for people who think Excel is a full contact sport. But of course, if a company can’t pay you the interest today, the totally rational response is to let them write you a bigger IOU.
Worse Credit Quality and Higher Fees
PC funds are laser focused on their non-accrual targets – because nothing says “healthy portfolio” like carefully avoiding the moment you must admit a loan isn’t, working. What’s the trick? The lender recognizes PIK interest as income without receiving a single dollar. Its financial aromatherapy, just close your eyes and breathe deep, the idea of cash is enough. Let’s review how this works: Borrowing Company can’t pay its interest, let’s call it $5M. They don’t have the cash, can’t generate the cash and frankly might not have seen the $5M since 2021. So instead of paying, that $5M just gets tacked onto the loan balance. Meanwhile, the Lender adds the $5M to their revenue today, despite the no-cash, zero-payment, maybe-someday-never reality. Why? Because income recognition without actual cash inflow does wonders to the Fund’s return targets. Conveniently, it also fattens the Fund manager’s billable AUA. Nothing boosts assets under advisement quite like adding imaginary interest to a loan the borrower already can’t service.
In a perfect utopian universe, the kind with rainbow spreadsheets and borrowers who magically pay their exploding loan debts, the set-up is great for funds. The PIK’d interest, earns more interest, compounding beautifully, and everyone rides off in the IRR sunset. IF the borrower pays; big IF. But, let’s be honest: if your child announces they are going to clean their room later [a vague, unmeasurable moment, only known to them] are you genuinely expecting to return from the grocery store to find that room spotless? Or are you expecting to trip over the same pile of laundry that’s been there since last Thursday? Same energy.
EXTEND, AMEND, PRETEND…THE END
We’re now watching the PC industry sprint — not walk — into widespread loan restructurings designed to “loosen” PIK terms. Translation: make it even easier for borrowers to not pay cash while still pretending everything is fine. If you dig into the filings of one particularly well-respected PC provider, you’ll find yourself tumbling down a rabbit hole lined with restructuring agreements buried across dozens of 8-Ks in just the last six months. The latest one — as of last week — jacked the PIK terms on a single loan portfolio from 2.5% to a jaw-dropping 17.5%. And that’s not even the high-water mark; plenty more are creeping up toward 20% like it’s the new industry trend.
And why stop there? PC Funds have every incentive to play along. This particular one is managing to a pristine sounding 7bps non-accrual rate. Seven. Basis. Points. If you can restructure a struggling loan so it technically doesn’t trigger non-accrual, you get to strut around showing off “strong covenants” without admitting that the borrower is basically paying you in vibes and optimism. What the end investor rarely realizes is that every time a loan gets reworked and the PIK component grows, the actual risk of the product silently ratchets up another notch. But hey — who’s counting?
In the background, you have Blue Owl Capital Corp, merging with itself – folding Blue Owl Capital Corp II back in like a financial matryoshka doll. Don’t forget the quiet nudging of their non-accrual target to 1.3%. A subtle shift, just casual enough most investors won’t blink, but meaningful enough to signal “don’t worry, everything is fine.”
The data is telling its own story. Lincoln International reports that PIK interest has doubled from 2021 to 2024. Even better: 57% of investments that now feature PIK interest didn’t have any PIK component at closing — meaning it wasn’t part of the plan, it was part of the problem. Lord Abbett chimes in with their own uplifting statistic: as of mid-2024, 12% of loans included PIK payments, nearly triple the rate of a year earlier. One can only imagine the plot twist we’ll see once all the 2025 data gets aggregated. Spoiler: it’s probably not going to be calming.
Rated, ‘Meh’?
Moody’s reports that U.S. life insurers held roughly 33% of their total assets in private credit at the end of 2024, up from just 20% a year earlier — a dramatic jump into loans that regulators treat as high-risk, meaning lower ratings translate directly into higher reserve requirements. Enter Egan-Jones, the tiny ratings shop that somehow churns out far more “significant” reports than peers many times its size, raising eyebrows about whether ratings are about accuracy or just sheer volume. And now Egan-Jones is under SEC investigation, because apparently, regulatory attention eventually catches up with even the smallest, scrappiest agencies. To make matters more interesting, the National Association of Insurance Commissioners [NAIC] quietly withdrew a recent report that suggested life insurers might be understating their risk and overreporting surplus — a tacit admission that official ratings and regulatory signals may mean absolutely nothing. All the while, MassMutual is under the microscope for whether billions in accruals were actually earned or just padded their books, with 16% of their $28B surplus being scrutinized. That’s right: phantom balance sheet revenue is back, quietly inflating reported earnings while doing nothing for actual cash reserves.
Regulators calculate policyholder reserves and risk-based capital ratios from disclosed assets and liabilities, which sounds responsible until you realize that if the surplus is stuffed with PIK interest and paper gains, insurers can look like Balance Sheet Warriors…propped up by post-it-notes and hope. The NAIC’s withdrawn report even hinted at the obvious: life insurers are piling into high-risk, illiquid private credit with valuations so flexible they practically do yoga. And here’s the kicker…the lower the ratings on these loans, the higher the reserve requirements regulators demand, which means more capital is locked away doing absolutely nothing productive. That’s right: every time a loan gets a “riskier” stamp, it’s like a giant ball and chain. The insurer can’t deploy that capital for more loans, more income, or anything useful. Meanwhile, Egan-Jones keeps churning out ratings like candy, the NAIC quietly retracts warnings, and everyone pretends the system isn’t a glorified illusion. On paper, insurers look robust and well-cushioned, but scratch beneath the shiny annual report, and its mostly puffery, PIK, and hope that no one asks too many questions. In other words: real yield takes a hit, risk quietly rises, and investors cheer anyway, because who’s going to check?
It’s basically a game of pretend: insurers pretend the loans are safe enough to earn returns, regulators pretend the reserves will magically protect policyholders, and everyone prays the borrower doesn’t default. Because the second reality pokes its head in, that nice little pile of “reserves” might not be nearly enough.
Schrodinger’s Cashflow
And there you have it: the private credit circus, where everyone wants the returns, and no one wants the scrutiny. JP Morgan traders? Thanks, but no thanks — the private credit clubs have politely frozen them out. It’s a full-blown Us vs. Them mentality: Wall Street can watch from the sidelines, but they’re not getting a seat at this table. Post-GFC, private credit funds swooped in on market scraps and they aren’t about to share. Start trading these loans publicly on any meaningful scale, and suddenly day-to-day marks come into play. Heaven forbid anyone actually sees what the numbers are doing. That would make it look a little too much like the public markets, where reality tends to interfere with fantasy returns. They’d have to mark day after day, and then everyone might notice that the magic carpet ride of PIK interest, creative valuations, and rising leverage isn’t exactly a smooth flight. Investors cheer because yields look great, ratings are reassuring-ish, and nobody’s asking the hard questions… yet. And if you think one day someone won’t, well, private credit is great at hiding until the curtain finally falls.
So, cheers to yields, PIK and smoke-filled spreadsheets…reality can wait.