Payment-In-Kind Interest in Fund Finance Transactions

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:

1. 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 to inadvertently violate fund debt limitations as a result of the compounding principal loan amount. 
2. How does interest rate volatility affect the effectiveness of PIK interest as a cash management tool? In a higher interest rate environment, the cost/benefit analysis of an increased principal loan obligation compounding at an elevated interest rate may incentivize a fund to make ordinary course interest payments based on the initial loan amount. Funds anticipating interest rate cuts may negotiate for PIK interest optionality as their principal obligations would compound at a lower rate in such an environment.
3. How do varying M&A and fundraising cycles impact the attractiveness of a PIK interest option? When investments haven’t yet generated returns (with necessary regular cash infusions from the fund, as a result) – or if a fund is in a non-profitable phase, ordinary course interest payments can be a strain on the fund’s liquidity. By reducing short term interest expenses via PIK interest, fund borrowers can utilize capital on hand to navigate difficult asset sale and/or fundraising conditions. A fund borrower is then able to align ultimate interest payments with anticipated cash flows from investment realizations when those distribution opportunities do arise.
4. Where is a fund borrower in its life cycle, and at what point may PIK interest be the most beneficial? When closed-end private investment funds have matured beyond their investment or commitment periods, they have typically called and deployed most of their uncalled capital commitments to acquire a portfolio of investments. As a result, these funds often have diminished or non-existent borrowing base availability under a traditional subscription credit facility. Certain banks and other non-bank lenders, recognizing that a fully invested fund has inherent value in its investment portfolio, will extend credit to these funds primarily based on the net asset value of the fund’s investment portfolio (a “NAV facility”). During the tenor of a NAV facility, access to cash flow may not be as readily available as in a typical subscription credit facility. For example, the fund may be waiting on underlying asset sales or investment distributions to repay debt and, as such, may not have a pool of unfunded capital commitments to call upon to make regular interest payments. Consequently, PIK interest optionality may be more attractive to a fund borrower under a NAV facility.
5. What are the tax and accounting implications of PIK interest? A fund borrower should consult with tax advisors to fully understand the effect that PIK interest may have on the timing and recognition of interest expenses at both the fund and investor levels. For example, PIK interest at a borrower’s option is typically treated as payable at the latest date it could be paid, and will typically result in draws being treated as issued with original issue discount (“OID”). Lender consent for PIK interest may be treated as a deemed exchange of outstanding draws for newly issued draws.  In certain cases, a loan with PIK interest may be subject to tax rules deferring or potentially eliminating deductions for such OID.  Provisions requiring cash payments of interest at certain points over the term of the loan are typically used to avoid application of such rules. Fund administrators and accountants charged with preparation of financial reporting should also be advised of the decision to utilize PIK interest.  Beyond tax implications, the increased principal obligation vs. interest expense may have balance sheet implications.  

Lender Considerations

 The lender upside for a fund borrower exercising a PIK interest option is an increased compounded interest payment at maturity (if PIK interest is utilized for the duration of the loan tenor) or at periodic interest payment dates (if PIK interest is only utilized to bridge cash flow for a few interest payment dates during the loan tenor). Regardless of how long a borrower elects PIK interest, a lender will see a greater yield on the facility as a result of an increased principal loan amount on which interest is owed. However, PIK interest increases leverage by not requiring periodic interest payments and may present downside risk of payment default for a company that exercises the option to hedge against cash flow concerns in the first place.

As Lenders determine whether to include PIK interest optionality in their loan documents, and if so, how to maintain adequate guardrails, they may consider:

1. Should the fund borrower re-certify representations and warranties made in the credit agreement each time it makes a PIK interest election? Fund borrowers are required to bring down representations and warranties and certify that no facility default has occurred each time a borrowing is made under the credit facility. While exercising a PIK interest option does not result in a new loan being funded, the principal amount owed by the fund borrower is increasing/compounding. Such a certification will also provide the lender an opportunity to reassess the value and sufficiency of the underlying collateral as it relates to the then-increased principal loan balance.   
2. What are certain drafting or term sheet considerations when hardwiring a PIK interest option into a form loan agreement? It’s not uncommon for lenders to impose limits on a fund borrower’s ability to capitalize interest – such as an established “PIK period” that expires prior to the scheduled maturity date, a “PIK premium” (an added interest margin), caps on how much interest can be capitalized and minimum cash interest requirements, particularly on benchmark rate components. To compensate lenders for delayed cash payments, a PIK premium may be applied in addition to the set benchmark and margin, which may be set or scaled depending on how much interest is capitalized. Precise drafting is critical to clearly define the PIK period to the extent applicable, notice mechanics for election (i.e., whether lender consent is required for each PIK election), and treatment of any PIK premium to avoid ambiguity and disputes.
3. Should the lender impose additional financial covenants upon a fund’s PIK interest election? With the bank foregoing ordinary course interest payments, there is an added incentive to ensure the fund remains solvent and maintains sufficient assets to satisfy debt obligations. Additional financial or reporting covenants as conditions to PIK interest may be a way to hedge against the risk of insufficient assets to satisfy principal obligations at maturity.
4. Does PIK interest added to the principal obligations exceed the total lender commitment? In a revolving credit facility context, lenders may consider allowing PIK interest only up to the maximum commitment amount for the principal obligations not to exceed the day-one lender commitment (subject to borrowing base availability). In a term loan scenario where the lender commitments are fully drawn on the closing date, capitalized interest will cause the principal obligations to exceed the day-one lender commitments. Therefore, imposing a cap on principal obligations (including PIK interest rolled into the principal) or increased pricing or fees on the portion of PIK interest can be a way for the lender to manage the borrower’s total exposure to the lender.
5. What are the regulatory or compliance considerations for lenders? A lender offering PIK interest optionality to their borrowers should consult with their own accounting and compliance teams, as reclassifying otherwise expected interest payments as increased principal obligations may affect financial statements and regulatory capital treatment. For example, a bank often will need to hold additional capital against capitalized PIK, interest, and may need to hold capital against a PIK option as a commitment to lend to the borrower at a future date. Additionally, a bank lender often may be required to reassess the borrower’s ability to repay and revalue or reappraise any collateral at the time a PIK option is exercised.  

Conclusion

PIK interest is a strategic tool for private investment funds to consider as part of their ongoing fund finance needs. The practice allows funds to optimize their cash flow management and navigate through interest rate and economic cycles more effectively. Lenders, particularly in the NAV financing space, continue adjusting the guardrails around PIK interest with the understanding that borrowers may increasingly seek PIK interest in a lower interest rate environment.