How much of a private credit fund's income is PIK?

Where payment-in-kind interest hides in a private credit fund's statements, and what it does to the distribution coverage the report leads with.

Julian R. Sterling · from How to Read a Private Fund's Financial Statements

Take the payment-in-kind interest from the non-cash adjustments in the statement of cash flows and divide it by total investment income; then deduct it, with discount accretion, from net investment income to see how much of the distribution was earned in cash. In an illustrative private credit fund, PIK is 14,400 of 96,000 of income, 15.00 per cent, and the distribution that net investment income covers 110.38 per cent is covered only 72.69 per cent in cash.

Worked in full in How to Read a Private Fund's Financial Statements by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

Why the question matters

PIK interest is earned but not paid: the borrower adds it to the principal of the loan instead of sending cash. Under accrual accounting the fund recognises it as interest income as it is earned, provided it expects to collect it, so it flows into net investment income (NII) exactly like cash interest. NII coverage of distributions, the ratio most reports lead with, cannot tell the two apart. The statements can, if you know where to look.

The assumptions

A fictional direct lending fund, one financial year, USD thousands. The incentive fee is simplified to 12.5 per cent of pre-incentive NII, with the hurdle already cleared.

Statement of operations, simplified
Line	Amount
Interest income received in cash	70,400
PIK interest	14,400
Accretion of original issue discount	5,200
Dividends and fee income, cash	6,000
Total investment income	96,000
Management fee	-14,000
Interest expense on borrowings	-12,500
Other expenses	-3,900
Pre-incentive net investment income	65,600
Incentive fee on income, 12.5%	-8,200
Net investment income	57,400
Distributions declared	52,000

Most statements of operations do not split interest income into cash and PIK. The split comes from the statement of cash flows, where the reconciliation of the net increase in net assets to operating cash shows "payment-in-kind interest capitalised" of minus 14,400 and "accretion of discount" of minus 5,200 as non-cash items. The schedule of investments, where each PIK loan's rate is shown as cash plus PIK, lets you check the order of magnitude.

The calculation step by step

PIK share of income = PIK interest / total investment income = 14,400 / 96,000 = 15.00%

Non-cash share = (PIK + accretion) / total investment income = 19,600 / 96,000 = 20.42%

NII coverage = NII / distributions = 57,400 / 52,000 = 110.38%

Cash NII (an approximation that ignores other accrual timing) = NII − PIK − accretion = 57,400 − 19,600 = 37,800

Cash coverage = 37,800 / 52,000 = 72.69%

Excel: =(NII+CF_PIK+CF_Accretion)/Distributions, with the two cash flow adjustments entered as the negative figures the statement prints.

PIK alone is 25.09 per cent of NII: a quarter of what the fund reports as earned income is a larger loan balance. Cash NII leaves 14,200 of the distribution uncovered, paid in practice from loan repayments, sales or the credit facility.

The result, and two refinements

PIK that comes back. PIK capitalised in earlier years is paid in cash when a loan is repaid. If the cash flow statement or the notes show 3,100 of PIK collected on repayments this year, cash earnings are 40,900 and cash coverage 78.65 per cent. That is the generous reading; it also assumes the remaining capitalised PIK will be repaid at par, which is exactly the question a rising PIK share raises.

Fees on income not received. Income-based incentive fees are normally calculated on NII including PIK and paid in cash. At 12.5 per cent the manager is paid 1,800 on this year's PIK, and 2,450 on all non-cash income, before the fund has collected any of it. Some agreements defer the fee on PIK until it is collected; the fee note says which.

What if the PIK share were higher?

Same total income and NII, more of it paid in kind
PIK share of income	PIK	Cash NII	Cash coverage	NII coverage
5%	4,800	47,400	91.15%	110.38%
10%	9,600	42,600	81.92%	110.38%
15%	14,400	37,800	72.69%	110.38%
20%	19,200	33,000	63.46%	110.38%
25%	24,000	28,200	54.23%	110.38%

The reported coverage is the same in every row; only the cash coverage moves. Each five points of PIK share takes about nine points off cash coverage here. PIK is not in itself a warning: some loans are structured with PIK from day one, on purpose. A PIK share that rises year on year, or PIK switched on by amendment for borrowers that used to pay cash, is a different reading of the same line, and the schedule of investments shows which loans changed.

How PIK compounds on a single loan is worked in how to calculate PIK interest on a private credit loan. The non-cash adjustments themselves sit in the reconciliation explained in how to read a private fund's statement of cash flows.

The common mistakes

Reading NII coverage as cash coverage. 110.38 per cent reported; 72.69 per cent in cash.
Leaving out accretion. Deducting PIK alone gives cash NII of 43,000 and coverage of 82.69 per cent, overstated by ten points.
Counting PIK as collected because it is in NAV. Capitalised PIK is part of the loan's fair value, and it is only as good as the borrower's ability to repay the larger balance.
Looking at one year. The trend in the PIK share across three or four years says more than any single figure.

Takeaway

PIK share = PIK capitalised, from the cash flow statement, over total investment income: here 15.00 per cent.
Cash NII = NII less PIK and accretion: 37,800, covering 72.69 per cent of a distribution that NII covers 110.38 per cent.
Check the incentive fee: 1,800 was paid on PIK not yet received.

The book's method for reading a fund's statements together, with the reconciliations as live formulas, is in the free workbooks for this book.

Questions readers ask

Where do you find PIK income in a fund's financial statements?

In the statement of cash flows, among the adjustments that reconcile the net increase in net assets to operating cash, usually as payment-in-kind interest capitalised. The statement of operations rarely separates it from cash interest. In the worked case the adjustment is minus 14,400, 15.00 per cent of total investment income of 96,000.

What is cash NII coverage?

Net investment income less non-cash income, PIK and discount accretion, divided by distributions. It shows how much of the distribution was paid from income actually received. A fund with 57,400 of NII and 19,600 of non-cash income has cash NII of 37,800, covering 72.69 per cent of a 52,000 distribution against 110.38 per cent reported.

Is a high PIK share a red flag for a private credit fund?

Not by itself: some loans are structured with PIK from the start. The warning signs are a PIK share rising year on year and PIK switched on by amendment for borrowers that used to pay cash. In the worked case each five points of PIK share takes about nine points off cash coverage while reported NII coverage stays at 110.38 per cent.

Read the whole case

This article is one calculation from How to Read a Private Fund's Financial Statements. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.

Get the book on Amazon →Free companion files

Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada

Also on this site

How do you calculate PIK interest on a private credit loan?Compound the PIK rate on the growing balance each period: $100M with 3.00 per cent PIK, quarterly, owes $116.12M after five years, and leverage drifts to 5.81x.
How do you read a private fund's statement of cash flows?Strip the gains out of the result, then split operating cash: a fund reporting 10,750 made 10,625 by selling 13,800 net, and burnt 3,175 to run.
Why does a private equity fund report a net investment loss?Income below running costs: 1,910 of interest and dividends against 5,110 of expenses gives a net investment loss of 3,200, minus 1.17% of average net assets.
What is a fund's multiple without its largest investment?Take the largest position out of the schedule of investments and recompute. A portfolio at 1.37x falls to 0.96x: one holding carries 110.1 per cent of the gain.
How is a fund's income allocated between the GP and the LPs?By capital before carry, then carry to the LPs alone: on a 13,600 result a 2% GP gets 272, LPs 10,478 after 2,850 of carry, and the GP's share drifts to 2.02%.
How do you calculate a private fund's expense ratio?Total fund costs over average net assets. Here fees and expenses are 1.72 per cent, 2.00 with facility interest and 4.08 with the carried interest accrual.

Reading guide: private equity and private markets → · All 1340 articles →

If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.