What Is PIK Interest? A Primer for Credit Fund Operations Teams

When a borrower defers cash interest payments by adding accrued interest to the loan principal, the arrangement is known as payment-in-kind, or PIK, interest. This structure has become increasingly common in direct lending, with S&P Global reporting that nearly 12% of BDC-held loans were making PIK payments in mid-2024, while approximately 14% of newly originated private credit loans now include PIK options at closing.

How Does PIK Interest Work?

Rather than paying interest in cash each period, the borrower capitalizes the interest amount onto the outstanding loan balance. The mechanics are straightforward:

• Interest accrues based on the stated PIK rate multiplied by the beginning principal balance

• The accrued amount is added to the loan principal at the end of each interest period

• Future interest calculations are based on the now-larger principal, creating a compounding effect

• The full balance, original principal plus all capitalized interest, comes due at maturity

For example, a $10M loan with 10% PIK interest would accrue $1M in the first year. In year two, interest accrues on $11M rather than the original $10M.

What Are the Common PIK Structures?

Credit agreements typically incorporate PIK in one of three ways:

• Full PIK: All interest capitalizes for the entire loan term, with no cash payments until maturity

• PIK toggle: The borrower can elect period-by-period whether to pay cash or capitalize interest, often subject to conditions or premium pricing

• Partial PIK: A portion of the interest (commonly 50% of the margin) may be paid in kind while the remainder is paid in cash

Most senior secured direct loans restrict PIK to a portion of the margin component only, not the base rate, and typically include a premium when the PIK option is exercised. Premium structures vary: some deals use a flat increase of 25-50 basis points, while others apply a tiered approach based on how much margin is capitalized.

Why Do Borrowers and Lenders Use PIK?

The motivations differ depending on circumstances. Growth-oriented companies may prefer PIK to preserve cash for expansion rather than debt service. Borrowers facing temporary cash flow pressure may use PIK to avoid covenant violations while working through operational challenges.

From the lender's perspective, PIK can be a competitive tool to win deals or a workout mechanism to support a borrower through a difficult period. Direct lenders often distinguish between "good PIK" negotiated at origination for strategic reasons and "bad PIK" that emerges when a borrower cannot service existing obligations.

What Are the Accounting Implications?

Fund controllers recognize PIK interest as income on the income statement even though no cash is received. The loan's carrying value on the balance sheet increases by the capitalized amount. On the cash flow statement, PIK interest is added back as a non-cash item.

This creates a timing difference between recognized income and cash receipts that affects NAV calculations and, for BDCs, distribution requirements. Funds required to distribute 90% of income face liquidity considerations when a meaningful portion of that income is non-cash PIK.

The compounding nature of PIK means that small percentages can grow substantially over a loan's life. A 15% PIK instrument, if held to maturity without prepayment, would roughly double in five years. Finance teams typically maintain separate schedules tracking PIK accruals, toggle elections, and the cumulative impact on each position's cost basis.