A direct loan split into cash and paid-in-kind interest, worked quarter by quarter: the balance, the cash coupon, the leverage and the loss in default.
PIK interest is calculated on the outstanding balance each period and added to that balance, so it compounds. A $100M loan with 3.00 per cent PIK, compounding quarterly, owes $116.12M after five years, not the $115.00M of a simple count, and the cash coupon is charged on the larger balance too. With EBITDA flat, leverage drifts from 5.00x to 5.81x without a dollar of new borrowing.
Worked in full in The Private Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A direct lender holds a five-year unitranche to a sponsor-backed business. The coupon is the reference rate plus 650 basis points, with the reference rate held flat at an illustrative 4.00 per cent, so 10.50 per cent all in. To protect the borrower's liquidity in the early years, 3.00 points of the coupon are paid in kind: added to principal each quarter instead of paid in cash. The remaining 7.50 per cent is paid in cash on the balance outstanding.
| Input | Value |
|---|---|
| Loan at closing | $100.0M |
| Reference rate, held flat (illustrative) | 4.00% |
| Spread | 650 bp |
| Total coupon | 10.50% |
| Of which paid in kind | 3.00% |
| Of which paid in cash | 7.50% |
| Compounding | Quarterly |
| EBITDA, held flat | $20.0M |
| Leverage at closing | 5.00x |
Each quarter has two lines and one update. The cash interest is the cash rate over four times the opening balance. The PIK interest is the PIK rate over four times the same opening balance, and it is added to principal at the end of the quarter, where it becomes the opening balance of the next.
Cash interestq = Balanceq-1 × 7.50% / 4 = Balanceq-1 × 1.875%
PIKq = Balanceq-1 × 3.00% / 4 = Balanceq-1 × 0.75%
Balanceq = Balanceq-1 + PIKq, so after n quarters: Balance = 100 × (1 + 0.75%)n
After 20 quarters: 100 × 1.007520 = $116.12M. Excel: =100*(1+3%/4)^(4*5) or =FV(3%/4, 20, 0, -100)
| Year | Cash interest | PIK accrued | Closing balance | Leverage |
|---|---|---|---|---|
| 1 | 7.58 | 3.03 | 103.03 | 5.15x |
| 2 | 7.81 | 3.13 | 106.16 | 5.31x |
| 3 | 8.05 | 3.22 | 109.38 | 5.47x |
| 4 | 8.30 | 3.32 | 112.70 | 5.63x |
| 5 | 8.55 | 3.42 | 116.12 | 5.81x |
| Total | 40.30 | 16.12 | 116.12 | 5.81x |
Three things show in the table. The PIK accrued in year one is $3.03M, not $3.00M, because quarterly compounding starts inside the first year. The cash interest rises every year although the cash rate never moves: by year five the borrower pays $8.55M of cash interest against $7.58M in year one, because the cash rate applies to a principal that PIK has enlarged. And the balance grows by 16.12 per cent over the life, which, with EBITDA flat, is 0.81 turns of leverage the credit committee never approved as new debt.
Total interest over the five years is $56.41M: $40.30M in cash and $16.12M capitalised. A loan paying the full 10.50 per cent in cash on a flat $100M would have produced $52.50M. The $3.91M difference is interest on interest, and it is the reason a PIK loan bought at par still yields exactly 10.50 per cent nominal, compounded quarterly (10.92 per cent effective annual). PIK at the contractual rate does not change the yield. It changes when the return is received and what has to go right for it to be received at all: $16.12M of the $56.41M arrives only if the borrower repays a larger balance at maturity.
The cash coverage looks better for it. On $20.0M of EBITDA, the all-cash loan covers year-one interest 1.90x; with 3.00 points in kind, cash interest is $7.58M and cover reads 2.64x. Most coverage covenants test cash interest, so a PIK toggle improves the very ratio the lender monitors while leverage, the ratio that drives recovery, gets worse.
Suppose the business stalls and, at maturity, the value available to the loan in a restructuring is $80.0M. On the all-cash loan the claim is $100.0M, a recovery of 80.0 per cent and a loss of $20.00M. On the PIK loan the claim is $116.12M: the recovery falls to 68.9 per cent and the loss to $36.12M. Every dollar of capitalised interest sits on top of the same collateral value, so here the whole $16.12M of PIK is lost on top of the $20.00M the all-cash lender loses. It was booked as income and never collected.
| PIK rate | 3 years | 5 years | 7 years |
|---|---|---|---|
| 2.00% | 106.17 (5.31x) | 110.49 (5.52x) | 114.99 (5.75x) |
| 3.00% | 109.38 (5.47x) | 116.12 (5.81x) | 123.27 (6.16x) |
| 4.50% | 114.37 (5.72x) | 125.08 (6.25x) | 136.79 (6.84x) |
| 6.50% | 121.34 (6.07x) | 138.04 (6.90x) | 157.04 (7.85x) |
The bottom row matters most in practice. When a borrower in difficulty negotiates a full or near-full PIK of the margin as part of an amendment, the balance grows fast: a loan fully in kind at 10.50 per cent doubles in about 6.7 years. If EBITDA does not grow, a loan that closed at 5.00x reaches 7.85x after seven years at 6.50 per cent PIK, which is a restructuring dressed as an income stream.
PIK is income for the fund's accounts on the day it accrues, and a fund that pays distributions out of net investment income can distribute cash it has not received. Track the share of income that is PIK alongside the yield; a rising share is one of the earliest signs in a credit portfolio.
Compound PIK on the growing balance, charge the cash rate on the same balance, and track leverage on the accreted balance, not the amount lent at closing. On this loan 3.00 points in kind add $16.12M to the claim and 0.81 turns to leverage over five years, while the cash coverage ratio improves. The Halstead lender's model in the free workbook for this case runs the cash and coverage side of a direct loan year by year; for how cash and total interest feed a coverage covenant, see how to calculate a fixed charge coverage ratio on a direct loan.
Yes. PIK interest is capitalised into the principal, so the next period's interest, cash and PIK alike, is charged on the larger balance. A $100M loan with 3.00 per cent PIK compounding quarterly reaches $116.12M after five years, against $115.00M on a simple count, and the cash coupon rises with it, from $7.58M in year one to $8.55M in year five.
No. If the PIK accrues at the contractual rate, a loan at 10.50 per cent with part of it in kind still yields 10.50 per cent nominal, compounded quarterly, because capitalised interest earns the loan rate. What changes is timing and risk: $16.12M of the return is deferred to maturity and depends on the borrower being able to repay a larger balance.
Coverage covenants are usually tested on cash interest, and PIK interest is not cash. On $20M of EBITDA, a $100M loan paying 10.50 per cent all in cash covers interest 1.90x in year one; with 3.00 points in kind the cash interest is $7.58M and cover reads 2.64x, while total leverage climbs 0.81 turns over five years.
This article is one calculation from The Private Credit Investor. 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.
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