Executive Summary & Background
Payment-in-kind interest (“PIK interest”) is the concept of deferring interest owed by a borrower under a credit facility to a later date. Instead of making regular cash interest payments to the lender in the ordinary course, the borrower can elect to satisfy interest payments by incurring additional debt under the facility and reclassifying interest owed as principal loan obligations. PIK interest may be beneficial to private equity and real estate investment funds as fund borrowers explore ways to maximize efficiency under their subscription facilities and/or NAV facilities, all while balancing cash on hand. In this Legal Update, we explore the concept of PIK interest and considerations for borrowers and lenders before exercising or offering a PIK interest option.
What to Consider When Assessing Whether to Use (or Offer) PIK Interest
Borrower Considerations
From a fund borrower’s perspective, despite the principal loan obligations increasing and compounding against the primary interest rate, PIK interest is a powerful cash management tool that allows the fund to deploy cash to make investments or satisfy operating expenses rather than make interest payments under a credit facility in the short term. By not using cash to pay interest, the increased liquidity may be particularly valuable in an industry where investment opportunities arise suddenly and require quick or substantial capital deployment, leading to higher returns over time if the cash is effectively deployed.
As the fund finance market continues to evolve around PIK interest provisions, borrowers may consider:
- Do fund LPAs and/or debt covenants in the loan documents permit increased principal loan obligations as a result of PIK interest?Where a fund borrower has leverage thresholds in its partnership agreements or loan documents, the borrower must be mindful of the increasing principal loan amount as a result of PIK interest so as not...