Paying interest in kind keeps cash in the fund, but the loan compounds while the collateral may not, so covenant headroom runs down by the calendar.
Interest paid in kind is added to the loan, so a NAV facility's LTV rises every quarter even when the portfolio value does not move. On an illustrative 120 million facility against an 800 million portfolio at 11 per cent PIK, compounded quarterly, the LTV climbs from 15.0 per cent to 20.8 per cent in three years on a flat portfolio and reaches a 25 per cent covenant after 4.7 years, without a single mark-down.
Worked in full in The Fund Finance Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
PIK is the feature that makes a NAV facility usable for a fund that has no spare cash: the borrower pays nothing until exits arrive. The cost is that the balance compounds while the collateral may not, so headroom erodes with the calendar, faster each year as the interest compounds. That drift is easy to miss in a covenant model that tests LTV at drawdown and then only stresses the denominator.
| Input | Value |
|---|---|
| Portfolio value (lending value of the investments), US$ millions | 800 |
| Facility drawn at closing, US$ millions | 120 |
| Opening LTV | 15.0% |
| Interest rate, all PIK, compounded quarterly | 11.0% |
| Maximum LTV covenant | 25.0% |
| Portfolio value growth (base case) | 0% |
Loan after t years = L0 × (1 + r ÷ 4)4t
LTV after t years = L0 × (1 + r ÷ 4)4t ÷ [V0 × (1 + g)t]
Years to breach = ln(covenant ÷ opening LTV) ÷ [4 × ln(1 + r ÷ 4) − ln(1 + g)]
In Excel: =LN(25%/15%)/(4*LN(1+11%/4)-LN(1+g)). With g = 0: ln(1.667) ÷ (4 × ln 1.0275) = 4.7 years, or 18.8 quarters.
The quarterly rate is 2.75 per cent, so the effective annual rate is 11.46 per cent, not 11. That difference matters: it is the growth rate the portfolio must deliver just to hold the LTV where it started.
| Year | Loan (US$m) | PIK interest added | LTV | Fund equity (US$m) | Value fall that breaches |
|---|---|---|---|---|---|
| 0 | 120.0 | 0.0 | 15.0% | 680.0 | 40.0% |
| 1 | 133.8 | 13.8 | 16.7% | 666.2 | 33.1% |
| 2 | 149.1 | 29.1 | 18.6% | 650.9 | 25.5% |
| 3 | 166.2 | 46.2 | 20.8% | 633.8 | 16.9% |
| 4 | 185.2 | 65.2 | 23.2% | 614.8 | 7.4% |
At closing the portfolio can lose 40.0 per cent of its value, down to 480, before the 25 per cent covenant bites. That is the figure in the credit paper. Two years later, with no change in any mark, the same covenant breaks on a fall of 25.5 per cent, and after three years on 16.9 per cent. More than half of the original cushion has gone to interest alone.
The drift also shows up on the equity side. PIK interest takes no cash out of the fund, but every dollar of it is a liability, so the fund's equity NAV falls from 680.0 to 633.8 over three years on a flat portfolio. Cash-pay interest would also reduce NAV, by the cash spent; the difference is that with PIK the cost stays inside the fund as a growing loan, so it shows up in the LTV as well as in the NAV.
Compounding adds less than people fear and more than they model. Three years of 11 per cent simple cash interest on 120 would be 39.6; quarterly PIK adds 46.2, so 6.6 of the extra comes from interest on interest. The bigger effect is not the extra 6.6 but the fact that the whole 46.2 sits in the numerator of the LTV instead of leaving the fund as cash.
| Portfolio growth a year | Value after 3 years | LTV at year 3, PIK | LTV at year 3, cash pay | Years to breach, PIK | Years to breach, cash pay |
|---|---|---|---|---|---|
| −10% | 583.2 | 28.5% | 20.6% | 2.4 | 4.8 |
| −5% | 685.9 | 24.2% | 17.5% | 3.2 | 10.0 |
| 0% | 800.0 | 20.8% | 15.0% | 4.7 | never |
| 5% | 926.1 | 17.9% | 13.0% | 8.6 | never |
| 8% | 1,007.8 | 16.5% | 11.9% | 16.2 | never |
| 12% | 1,123.9 | 14.8% | 10.7% | never | never |
A gentle 5 per cent annual decline, the kind of drift a tail-end portfolio shows as its best assets are sold first, breaches the covenant in 3.2 years with PIK against 10.0 years with cash interest. PIK more than triples the speed of the breach. Even 8 per cent annual growth, a respectable result, still lets the LTV rise, to 16.5 per cent after three years, because the loan compounds at 11.46 per cent. Only growth above that rate makes the LTV fall.
Real facilities rarely run that long without repayment: a cash sweep on exits, covered in how long a NAV loan takes to repay from a cash sweep, pulls the balance down in steps. But the sweep only works when exits happen, and PIK is usually chosen precisely because the borrower does not expect them soon.
The usual error is to stress only the denominator: run the portfolio down 10, 20 and 30 per cent against the drawn amount at closing, and report the headroom as the answer, as in how far NAV can fall before a NAV facility breaches its LTV covenant. With PIK, that static headroom is only true on the closing date. The correct test is a dated one: project the loan with compounded interest to each test date, then apply the stress to the portfolio value at that date. A 25.5 per cent cushion at year 2 is a very different credit from a 40.0 per cent cushion at closing, and the lender's model will already show it.
The second error is to use the nominal rate. At 11 per cent compounded quarterly the break-even growth is 11.46 per cent; using 11 understates the drift each year.
For the borrower's model: add a PIK toggle and a test-date column. If the LTV at the next three test dates, on flat values, already uses half the covenant headroom, negotiate a step-up in the covenant, a partial cash-pay option, or a lower PIK margin before signing.
PIK converts time into leverage. On a flat portfolio, an 11 per cent PIK facility moves from 15.0 to 20.8 per cent LTV in three years and breaches a 25 per cent covenant in 4.7, so the covenant headroom has to be read as a number of years, not a percentage. The NAV facility underwriting worked in the book, from reported NAV to lending value, is set out in the free workbook for this book.
Growth equal to the effective annual PIK rate. At 11 per cent compounded quarterly that is 11.46 per cent a year, not 11. Below it the LTV rises every quarter; above it the LTV falls. In the illustrative case, 8 per cent annual growth still leaves the LTV at 16.5 per cent after three years, up from 15.0.
Yes, as cash-pay interest would. No cash leaves the fund, but the accrued interest is added to the loan, which is a liability. On a flat 800 million portfolio with a 120 million facility at 11 per cent PIK, the fund's equity NAV falls from 680.0 million to 633.8 million over three years with no change in portfolio value, and the larger loan also pushes up the LTV.
It depends on the value path. In the illustrative case, with a 25 per cent maximum LTV and portfolio value falling 5 per cent a year, the facility breaches after 3.2 years with PIK against 10.0 years if the same 11 per cent rate is paid in cash. On flat values a cash-pay facility never breaches, while the PIK one breaches after 4.7 years.
This article is one calculation from The Fund Finance Professional. 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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