Providing borrowers with the flexibility to defer the payment of interest is not a new concept, but it has become a more prevalent option in the last few years as businesses have suffered from a perfect storm of COVID, rising interest rates, inflation and market volatility that has seen cash flows put under strain. This flexibility has taken different forms: in the bond markets, ‘pay if you can’ mechanics established themselves; in higher leveraged deals, Holdco PIK facilities became a common feature; and in leveraged senior loans, ‘payment in kind’ provisions (“PIK Toggles”) developed as a useful tool for borrowers.

It is the PIK Toggle that we shall focus on in this note as it has both assisted borrowers in managing ‘bumps in the road’ while also allowing many private credit funds to further distinguish themselves from banks who often struggle with deferment of interest.

Key points to consider are:

  • Obligation or Option? Does the capital structure require a fixed element of PIK Toggle from day one, or is this to be a flexibility the borrower can draw upon subject to meeting certain conditions? A fixed PIK provides certainty but will require the capital structure to be able to accommodate it potentially through its full term, whereas an option to PIK (while less certain) is more flexible.
  • What can PIK? PIK Toggle provisions will usually limit the portion of interest that can be capitalized. This can be restricted to capitalizing only the margin or include the entire interest payment, i.e., also the reference rate (EURIBOR, SONIA, SOFR, etc). While a few more borrower-friendly deals allow the full interest rate to be subject to PIK, the vast majority of transactions restrict PIK to the margin only.
  • Premium: While PIKs are flexible tools, they also come at a price. Usually an additional premium applies to the amount of the margin that is to be converted into PIK. It is important to ensure that it is clear how that premium is applied both in terms of:
    1. whether the premium itself is fixed (i.e., irrespective of how much is converted), multiplies (i.e., 25 basis points increase per 50 basis points converted) or is tiered (i.e., the premium increases the more you convert – 25 bps per 100 bps up to 1% and 50bps per 100 bps above 1%), and
    2. whether in tiered PIK structures, the premium applies per threshold rather than all at the higher premium if the threshold is exceeded.
  • Capitalization: It is equally important to be clear as to when and how often the PIK Toggle capitalizes. Usually this will be linked to interest periods, therefore these provisions need to be checked to ensure they work in tandem with the PIK mechanics. The more frequently the PIK capitalizes, the greater the compounding, which increases the loan for the borrower not only by compounding the interest itself, but also of the premium.
  • Mechanics: For a PIK Toggle to apply, no default will need to be continuing and also an election will need to be made. From the borrower’s perspective, the greater flexibility is to make the PIK election at the last possible moment (i.e., a short period before the end of the interest period), but this does not necessarily work for lenders who may require the election to be made prior to interest period commencing. A mechanism should also be included going forward as to whether the election remains or is rescinded.
  • Interest or Capital?: All parties should understand how this capitalized PIK is treated under the Finance Documents going forward. While it began life as interest, post-capitalization PIK is then part of the principal of the loan and should be treated as such for all covenants (and indeed be subject to non-call and prepayment fees as well).
  • Other Restrictions: In some deals and structures, lenders may require other restrictions to apply such as requiring a minimum cash pay amount or otherwise restricting the amount of PIK Toggle that can apply by quantum or limiting the time period for a PIK Toggle, e.g., a maximum of 12 months, etc., and/or not allowing it to apply in consecutive months or quarters. In some deals, there may also be requirements for PIK Toggle principal to be prepaid before original principal.
  • Jurisdictional and Tax Considerations: When structuring PIK Toggles, attention needs to be given to any tax or accounting repercussions that may flow either for the borrower or the lender from incorporating a PIK Toggle. These factors can affect the timing of capitalization and the required mechanics as well as giving rise to different withholding tax treatments.
  • Conclusion: While PIK Toggle mechanics have been a helpful financial innovation for borrowers, it needs to be remembered that if the original business plan is not met and/or a suitable exit is not achieved, a PIK Toggle can become a millstone around the neck of the borrower, eating into equity value for the sponsor and/or management and adversely affecting the appearance of the balance sheet. However, if sensibly employed, PIK Toggle options can provide significant advantages and flexibility to borrowers in a variety of scenarios.