Covenant-Lite to Covenant-Void? Navigating Private Credit Risk

Private credit has exploded into a $1+ trillion asset class and become a mainstream fixture in institutional portfolios. After years of growth fueled by easy credit and low interest rates, the market is now entering its first significant default cycle. his emerging phase is raising questions about risk: have covenant-lite loans effectively turned into covenant-void loans? Are PIK (Payment-in-Kind) interest structures quietly inflating leverage? In this post, we explore these concerns – focusing on what they mean for institutional investors and portfolio risk management. We maintain a high-level view with brief examples, examining how covenant erosion and PIK build-ups might impact private credit portfolios as defaults tick up. The goal is to equip Limited Partners (LPs) with practical insight into how to navigate today’s private credit landscape.

Private Credit’s First Big Test: A $1 Trillion+ Market Enters Default Cycle

After the Global Financial Crisis, private credit rapidly evolved from niche strategy to a $1+ trillion market. By 2024, private credit AUM had swelled to nearly $2 trillion, thanks to investors’ search for yield and banks retreating from middle-market lending. This boom occurred during an era of ultra-low interest rates when defaults were scarce – indeed, private credit has yet to weather a full credit cycle. That benign backdrop is changing. As interest rates spiked and economic conditions tightened, signs of distress are emerging in private credit portfolios. According to Fitch, the U.S. private credit default rate climbed to 5.7% by early 2025, up from virtually 0% in 2022. A number of sponsor-backed borrowers have already stumbled into restructurings, testing lenders’ resolve.

Source: Fitch Rating, Preqin

This is private credit’s first big test: a rising tide of defaults and workouts that will reveal how robust the asset class truly is. Unlike public high-yield or broadly syndicated loans, private credit deals are often bespoke and held by concentrated lender groups – which can be a double-edged sword. On one hand, direct lenders may work closely with borrowers (and private equity sponsors) to avert or mitigate defaults. On the other, the structures and protections baked into these loans will determine how recoveries play out. In a market that grew fast amid fierce competition, some are asking whether investor protections were sacrificed for growth, leaving portfolios more vulnerable. This section sets the stage: private credit is large and important, but it’s now facing cyclical stress for the first time. The following sections delve into two key risk factors – covenant erosion and PIK interest build-ups – and how they could shape outcomes in this default cycle.

Covenant Erosion: From Covenant-Lite to Covenant-Void?

One prominent concern is covenant erosion – the steady weakening of lender protections in loan agreements. In the chase for yield and deal flow, many private credit lenders agreed to “covenant-lite” terms, which lack the traditional financial maintenance covenants that trigger early warnings. In fact, across leveraged loans broadly, over 90% of senior loans now carry no meaningful covenants. Even in private credit, especially larger club deals that compete with syndicated loans, maintenance covenants have become rare – fewer than 10% of loans above $500 million include them. This trend has prompted the provocative question: are we moving from covenant-lite to effectively covenant-void?

Source: Pitchbook, Bloomberg

Covenant-lite loans omit the periodic financial tests (such as leverage or interest coverage ratios) that historically gave lenders an early warning system and bargaining power when a borrower’s performance deteriorated. Without these tripwires, lenders might only learn of trouble when a payment is missed or when liquidity is almost gone – by then, options can be limited. Weaker documentation also opens the door for borrowers (and their private equity sponsors) to engage in “creative” maneuvers to stave off default on their terms. For example, loose covenants and permissive debt baskets have allowed some companies to incur new debt senior to existing lenders or to transfer assets to new subsidiaries as collateral for fresh financing. uch actions create “creditor-on-creditor violence,” where certain lenders gain priority at the expense of others. In a tightly negotiated deal, these moves would be restricted; in covenant-lite deals, they can catch passive lenders off guard.

To be sure, not all private credit is covenant-lite. Middle-market direct loans often still include at least one maintenance covenant (e.g., a leverage ratio), reflecting the tighter documentation in bilateral or club deals. Private lenders also pride themselves on closer relationships and monitoring, which can offset some covenant looseness. Nevertheless, as money flooded into private credit, terms loosened across the board. Lenders – eager to deploy capital – compromised on covenants amid intense competition, especially for sponsor-backed deals in hot markets. The result is that many private credit portfolios today contain loans with fewer protective guardrails than a decade ago. As the default cycle unfolds, this covenant erosion will be tested. Will covenant-lite loans delay defaults and give companies time to recover, or simply defer the day of reckoning and lead to steeper losses? This section underscores that covenant quality is a critical factor for allocators to watch, as it directly influences portfolio risk and recovery values in distress.

PIK Toggle and Build-Ups: Yield Now, Pain Later?

Another feature garnering scrutiny is the rise of Payment-in-Kind (PIK) interest structures in private credit. PIK loans allow borrowers to defer cash interest payments, instead accruing the interest to the loan principal. This can be a lifeline for companies facing cash flow strain – but it effectively turns interest into additional debt. In recent years, PIK toggles have crept from being a tool for distressed or junior debt into more mainstream private credit deals. As interest rates climbed, some highly levered borrowers negotiated PIK options to conserve cash and avoid default. The result is a build-up of debt over time: interest that isn’t paid today must eventually be paid (with interest on interest) tomorrow.

The prevalence of PIK in private credit is not just anecdotal – it’s measurable. By mid-2024, roughly 10% of the interest income reported by BDCs (business development companies, a proxy for direct lending portfolios) was coming from PIK rather than cash. Similarly, loans carrying PIK provisions made up about 11–12% of BDC loan holdings by value, before marking its first decline in over a year as a share of BDC assets, which grew sharply in the third quarter, led by nontraded BDCs (including private and perpetual nontraded) at about 56% year on year. This came after a steady rise of PIK-paying loans within BDC portfolios from second-quarter 2023 through second-quarter 2024 caught investor attention. 

Source: S&P Global; As of April 2025

Some private credit funds even saw PIK interest account for low double-digit percentages of their total interest income. These figures reveal a concerning trend: a portion of yield that investors see from private credit is “pencil yield” – income that is accrued on paper but not actually received in cash. This hidden leverage builds up the longer PIK continues, increasing the eventual burden on the borrower.

PIK toggles can mask underlying stress. A borrower that would struggle to pay 10% cash interest can instead PIK that interest, avoiding a near-term default. But the debt grows in the background, and leverage ratios creep higher without outward signs. For lenders, PIK can be a double-edged sword: it may preserve a struggling company and potentially yield a higher interest rate (PIK loans often carry an extra premium), but it defers risk to the future. If the company’s fortunes don’t improve, PIK simply kicks the can down the road, leading to a larger bill (and potentially a harder default) later. In a benign scenario, PIK gives a growth-oriented borrower breathing room to invest cash elsewhere, and everyone wins as the company grows into its capital structure. In a harsh scenario, PIK just amplifies losses – the lender ends up with a bigger claim, but on a deteriorated business that can’t meet its obligations.

For institutional allocators, the key is to look under the hood of portfolio yields. How much of the return is paid-in-cash vs. PIK? A fund bragging of double-digit yields may be materially less attractive if a chunk of that is PIK interest that could evaporate in a default. Transparency and monitoring are crucial here. LPs should engage with their managers to understand how PIK exposure is managed: Are PIK provisions used sparingly as a last resort, or are they built into many loans upfront? How are managers tracking the cumulative PIK accruals and the health of those borrowers? PIK isn’t inherently bad – it can be a useful tool in workouts or for companies making productive use of cash – but excessive reliance on PIK is a warning sign. This section highlights that what you don’t see (deferred interest obligations) can hurt you, and that “yield with caveats” requires careful risk assessment.

Navigating Defaults with Weaker Protections

As private credit enters a more challenging phase, the combination of looser covenants and PIK build-ups will shape how defaults and recoveries play out. Covenant-lite documentation means fewer early interventions – some troubled borrowers might limp along longer than they would have under tighter terms. In the short run, this can reduce technical defaults and give LBO sponsors time to try turnarounds. Indeed, during the early 2020 pandemic downturn, many private lenders exercised discretion and patience with borrowers, and default rates stayed unexpectedly low.

Source: LCD. As of March 2023. “Other” includes general corporate purposes, refinancing and other M&A activity. For illustrative purposes only.

However, when problems can no longer be papered over, the ultimate outcomes may be more severe. If a company has been accumulating debt via PIK and there were no covenants to force a restructuring earlier, the eventual default could be sudden and leave lenders with deteriorated collateral and higher debt loads.

We are already seeing lenders grapple with these dynamics. In some recent cases, direct lenders have had to take control of companies from equity sponsors in restructurings when cash ran out. For example, one group of private lenders agreed to swap part of their debt for equity and even toggle remaining interest to PIK to give a distressed borrower (a market intelligence company) more runway. This illustrates a pragmatic approach – using PIK flexibility as a workout tool – but it also underscores that lenders ended up owning a struggling company, something they might have avoided if covenants had prompted action sooner. In another case, a sponsor-owned firm was able to move valuable assets out of the lenders’ collateral pool to raise new funding, a maneuver made possible by loose covenants (often referred to as a “drop-down” transaction). These examples are cautionary tales: they show how weaker credit terms can limit lenders’ bargaining power and lead to more complex, less favorable outcomes in distress.

For LPs allocating to private credit, the takeaway is not to avoid the asset class – but to ensure your managers are prepared for this cycle. This means robust workout expertise, proactive monitoring, and discipline in underwriting new deals. Private credit lenders with strong origination standards may still enforce covenants (formal or informal) by keeping close tabs on borrowers. The relationship-driven nature of direct lending can be an advantage in workouts – lenders might get earlier heads-up through informal channels even without covenant triggers, and can negotiate quietly out of court. However, LPs should question how managers will handle a scenario with rising default volumes. Are they staffed for potentially contentious restructurings? How will they avoid being on the losing end of “liability management” battles that pit creditors against each other? This section makes it clear that the default cycle will test each manager’s underwriting and negotiation mettle, especially when legal protections are lacking. The outcome for investors will depend on both the initial deal terms and the manager’s skill in navigating troubled credits.

Source: Moody’s, Barclays Research, as of August 2024

Navigating Defaults with Weaker Protections

For institutional investors, private credit remains appealing – floating yields are high and diversification benefits are evident. But the concerns around covenant-lite loans and PIK interest should prompt a closer examination of risk management in this asset class. Allocators should approach private credit with a balanced view: acknowledge the strengths, but be mindful of the new risks in the current vintage of loans. Here are a few practical implications and considerations:

• Due Diligence on Covenant Quality: When committing to a private credit fund or mandate, LPs can inquire about the typical covenant package on deals. Does the manager still include covenants (and how tight are they)? Understanding whether a portfolio skews toward “cov-heavy” middle-market deals or “cov-lite” large deals helps in calibrating risk expectations. In a portfolio with many covenant-lite loans, investors should expect less early warning on credit issues and possibly lower recovery rates. Allocators might favor managers who demonstrate discipline in maintaining lender protections, especially in a borrowers’ market.
  
  
  Source: Moody’s Investor Service
  
  

• Scrutiny of Yield Composition: As discussed, not all yield is created equal. LPs should look at how much yield comes from PIK or other non-cash forms. A fund heavily reliant on PIK interest for its return could face a cash flow shortfall if those borrowers falter. It may be wise to stress-test the portfolio’s income: for instance, what happens if all PIK interest had to be written off or converted to equity in a restructuring? Managers should be transparent about PIK exposure and have a rationale for each case (e.g. a high-growth borrower using PIK judiciously versus a distressed name using PIK to survive).

• Manager Selection and Expertise: In this phase of the cycle, experienced credit teams can make a big difference. LPs allocating to private credit should favor managers with proven workout experience and creditor rights savvy. This includes familiarity with restructuring processes, creative solutions, and the ability to lead creditor groups when things go south. A manager who invested in loose documents but lacks restructuring chops could be caught flat-footed. Conversely, a manager with strong legal and restructuring expertise might still protect value even in covenant-lite situations by leveraging relationships and creative dealmaking. Portfolio construction matters too – diversified exposure across sectors and sponsors can mitigate the impact of any single problematic deal.

• Ongoing Monitoring and Communication: Allocators don’t have to be passive. They can establish regular dialogue with private credit managers to monitor credit metrics and portfolio health. Many LPs in separately managed accounts or partnerships now expect quarterly credit updates, including any amendments, covenant waivers, or upticks in PIK usage. Early communication of emerging risks allows LPs to anticipate issues in their broader portfolio context. Additionally, LPs might ask managers how they are preparing for potentially higher defaults – for example, building reserves, bringing in advisors, or selectively exiting weaker positions while secondary market liquidity exists.

Conclusion

In essence, the challenge (and opportunity) for allocators is to balance yield against protections. Private credit can still deliver attractive, stable returns, but it is not a “set and forget” asset class, especially not now. By selecting skilled managers and staying attuned to covenant and PIK risk factors, LPs can confidently navigate this space without being blindsided by the next default wave. The final message is one of prudent optimism: private credit is maturing through its first real test, and while some practices like covenant-lite loans and PIK interest add risk, they can be managed with the right approach. Allocators who remain vigilant and informed can continue to reap the benefits of private credit while mitigating the pitfalls of covenant erosion and hidden leverage in their portfolios.