Paid-In-Kind (PIK) interest features allow borrowers to add interest to the principal of a loan versus making cash payments. This is different than traditional interest payments where borrowers pay interest in cash at regular monthly or quarterly intervals.
A growing number of private market loans are being structured or amended to include PIK interest in a variety of different ways. Why? Borrowers are hoarding cash and seeking extended runways which fits nicely with lender demand for solutions because immediate liquidity prospects are limited for most borrowers.
PIK BASICS
PIK interest generally accrues in three different ways. First, “full PIK” loans require the entirety of the interest to be converted into principal. Second, “split PIK” loans require borrowers to pay part of the interest in cash with the remainder being converted into principal. Third, “(3) “toggle PIK” loans permit the borrower to pay cash or accrue PIK interest on a payment by payment basis (or time period by time period basis) if certain conditions in the loan agreement are met. It is also important to note that “In Kind” payments could also be paid with non-cash assets such as securities, real property, or inventory.
Therefore, principal balance of the loan grows whenever PIK interest accrues as do the required cash interest or PIK payments over the life of the loan. The principal increases and compounds over time without any amortization. Borrowers and lenders understand that the principal can double or triple quickly.
Paying off or refinancing PIK interest loans becomes more difficult as the principal increases. They are not for the faint of heart.
ANALYSIS OF CERTAIN PROVISIONS
Mandatory return to cash triggers automatically require borrowers to discontinue PIK interest and resume making cash interest payments. This allows lenders to take advantage of improved borrower performance. The most common triggers are (i) a liquidity events (equity financing), (ii) revenue milestones or (iii) maintenance of a minimum cash balance.
Toggles that allow borrowers to switch between PIK interest and cash pay interest may also be tied to certain events or predefined performance metrics. For pre-profit venture companies, toggles can tie to projected cash runways such that PIK interest can accrue only when the cash runway exceeds a certain amount. Toggles are typically not free. Lenders are paid a premium called a “PIK toggle spread” when the borrower elects to make interest payments in kind rather than in cash. PIK toggle spreads compensate lenders for the increased risk associated with PIK interest and discourages borrowers choosing to make larger PIK interest payments. PIK toggle spreads may be determined by many factors including borrower’s financial condition, the length of the PIK availability period, and market conditions.
Of course, toggles can also be “partial PIK toggle spreads” such that interest payments can be part PIK and part cash. Unsurprisingly, the toggle spread premium usually applies only to the PIK portion of the interest payment. which can create more nuanced alignment between the borrowers and lenders.
PIK interest payments can be limited to a certain time period. The opportunity to pay PIK interest could be a fixed duration. It could be ties to a specific parameter or event.
David Seidman is the principal and founder of Seidman Law Group, LLC. He serves as outside general counsel for companies, which requires him to consider a diverse range of corporate, dispute resolution and avoidance, contract drafting and negotiation, and other issues.
He can be reached at david@seidmanlawgroup.com or 312-399-7390.
This blog post is not legal advice. Please consult an experienced attorney to assist with your legal issues.
