PIK Interest: Interest Paid in More Debt

Payment-in-kind (PIK) interest is interest paid in more debt rather than in money. The unpaid coupon is added to what is owed and then earns interest itself, so the balance compounds while nothing leaves the borrower. The lender books income it has not received. On position 3 of Nilgiri Direct Lending Fund I, invented, Rs 30,00,00,000 becomes Rs 35,64,30,000 in two years.

The arrangement is small enough to hold in one hand. A lender advances a cousin Rs 1,00,000 for a year at ten per cent. At the end of the year there are two ways that interest can reach the lender. The cousin can hand over Rs 10,000, in which case Rs 10,000 has left the cousin and arrived with the lender. Or the two of them can agree that the Rs 10,000 is simply added to what is owed, so nothing changes hands and the debt becomes Rs 1,10,000. In both cases the cousin has paid the interest for the year. In only one of them has any money moved.

The second arrangement is payment-in-kind interestInterest settled by adding to the amount owed rather than by paying cash., and it is written into loan documents at every size from that cousin to a Rs 30,00,00,000 facility. Everything difficult about it comes from one split: the lender books more income and receives less cash, and both halves of that sentence are true at the same time. A reader who holds only the first half will read a rising income line as money arriving. A reader who holds only the second half will think nothing has happened at all. Both halves have to be held at once, and one invented loan, worked to the rupee, is what carries them here.

Position 3 is one of the eight loans in the book of Nilgiri Direct Lending Fund I, an invented private credit fund managed by Nilgiri Alternatives Advisors Private Limited with Nilgiri Trusteeship Services Private Limited as its trustee. The borrower is not named anywhere in this record. The principalThe amount borrowed, before any interest is added to it. is Rs 30,00,00,000. Every rate quoted here is that invented fund's own contracted rate on that one position, agreed in that one document. None of them is a statement about what private credit costs in India, and what any of it will eventually be worth is a question about a borrower rather than about a rate.

What does it actually mean to pay interest in more debt?

Paying interest in more debt means the obligation is settled without a transfer. The document says the borrower shall pay interest at a stated rate, and then it says that some or all of that interest, instead of being remitted, shall be capitalised: added to the outstanding principal, from which moment it is treated exactly as though it had been borrowed on day one. The interest has been paid. Payment came in the currency of more debt.

Position 3 after its reset carries two rates inside the same clause. Eight per cent a year is the cash couponThe part of the interest that is actually paid in money., and that part is remitted. Nine per cent a year is the in-kind part, and that part is capitalised. Added together, the two rates give a blended rateThe cash rate and the in-kind rate added together to give the total contracted rate. of seventeen per cent, the total the borrower has contracted to pay for the year. Seventeen per cent is what the loan costs, and eight per cent is what the borrower has to find. Those are two different facts about one clause, and most of the misreading on this subject comes from collapsing them into one number.

The in-kind half does one thing on arrival, and that one thing is the whole of the mechanism. The capitalised coupon does not sit in a separate ledger marked unpaid. The coupon becomes principal. From the first day of year two it is indistinguishable from the original Rs 30,00,00,000 and it earns the same seventeen per cent as everything else. Capitalisation is why the arithmetic of the second year looks different from the arithmetic most readers expect.

How does the amount owed grow, and how fast?

Slowly at first, and then in steps that get bigger every year. Each year's rate is charged on a number that last year made larger. The growth of the balance as unpaid coupons join it has a name: accretionThe growth of the amount owed as unpaid interest is added to it.. Here it is on position 3, in whole rupees, with the nine per cent in-kind rate this invented fund contracted for.

At the start the borrower owes Rs 30,00,00,000. Nine per cent of that is Rs 2,70,00,000, and because that coupon is paid in kind it is added rather than remitted, so after one year the borrower owes Rs 32,70,00,000. Now year two. Nine per cent is charged again, but not on Rs 30,00,00,000. The base is Rs 32,70,00,000 instead, the year's interest is Rs 2,94,30,000, and the balance goes to Rs 35,64,30,000. Year two added Rs 24,30,000 more than year one did, and that Rs 24,30,000 is exactly nine per cent of the Rs 2,70,00,000 that year one added. Interest on interest, arriving on schedule and in writing.

Hold the two totals next to each other. The difference between them is the whole idea. Had the nine per cent been charged on the original Rs 30,00,00,000 in both years, the borrower would owe Rs 35,40,00,000 after two years. The borrower owes Rs 35,64,30,000 instead. Two years is a short window and the gap inside it is small, worth saying plainly rather than dressing up. The gap is not the point. The mechanism producing the gap is the point, and the mechanism does not stop.

The third answer there is the instinct of a reader meeting this for the first time, and it is worth naming even where it was not the answer chosen. Nothing was paid, so surely nothing happened. But something was paid. The obligation was discharged in full, on time, in a form the document permits, and the record of that discharge is the larger number the borrower now owes. Paying in kind is not the same as not paying, and a borrower who simply failed to remit would be in default rather than in compliance.

What is the cash coupon actually charged on?

Nobody asks this question and everybody needs it answered. Two loans with identical rates produce different numbers depending on the answer. On position 3 the answer is fixed and it holds every time a cash figure appears: the eight per cent cash coupon is charged on the original Rs 30,00,00,000 and does not accrete, so it is Rs 2,40,00,000 a year, flat, in every year. Only the in-kind rate is charged on the growing balance.

Put the two bases side by side and the asymmetry is obvious. The in-kind rate meets Rs 30,00,00,000 in year one and Rs 32,70,00,000 in year two, so its accrual grows. The cash coupon meets Rs 30,00,00,000 in both years, so its cash does not. The accreted balanceThe original principal plus every unpaid coupon added to it since. is the base for one rate and not for the other, and that single asymmetry is doing more work here than any of the rates are.

The last line of that caption deserves saying in full. A reader can work it out and then feel let in on something. If both rates were charged on the accreted balance, the split between them would be eight parts cash to nine parts in kind in every year forever, and the cash share would sit at 47.1 per cent and stay there. The cash share falls to 44.9 per cent in year two precisely because the cash side is pinned to a number that stopped moving. The falling cash share is not a fact about payment-in-kind interest in general but a fact about this loan's convention, and the convention is stated wherever a figure from it appears.

Position 3 did not start life with these two rates. The loan began at eleven per cent in cash and five per cent in kind, and the move to eight and nine came out of a restructuring agreed after a covenant test went the wrong way, before any payment was missed. Why that restructuring happened, what was negotiated alongside it and what a lender is doing when it sits down to renegotiate rather than enforce is a separate subject with its own treatment. The two rates are taken as given, and what matters here is what they do.

What does the lender record, and what has it received?

Two different numbers, for the same loan, in the same twelve months. In the first year after the reset the fund records Rs 5,10,00,000 of interest income on position 3, being the Rs 2,40,00,000 of cash coupon plus the Rs 2,70,00,000 that was added to the balance. The fund has received Rs 2,40,00,000. Rs 2,70,00,000 of that year's income is not money and has never been money; it is an increase in what one borrower owes.

The word for the first number is recognised incomeIncome recorded for a period, whether or not any cash arrived., and there is nothing irregular about it. The interest was contractually due, it was contractually settled, and a lender records interest as it is earned rather than as it is banked. The recognition is right. The trouble comes downstream of the recognition, in a reader who sees an income line and pictures a bank balance.

Think of a tuition teacher with twelve students. Ten pay at the end of every month. Two have agreed to pay at the end of the year and the teacher has written that down. The teacher's income for the month is all twelve fees, and the teacher would be wrong to record anything less. The money in the teacher's hand is ten. Nothing dishonest has happened anywhere in that sentence, and the teacher still cannot buy anything with the other two.

Why would a borrower ask for this?

Because it converts a payment problem into a size problem, and the two are not equally urgent. A business that cannot find Rs 3,30,00,000 this year and does not remit it has missed a payment, with everything that follows from that. A business that has agreed to add Rs 2,70,00,000 to its balance instead has done nothing of the sort. The business is current, it is in compliance, and its bank account is untouched.

Everybody has met this at household scale. A household stretched by a wedding does not usually want a cheaper loan; it wants a loan whose payments start later, and it will accept a larger total to get that. A shopkeeper facing a slow quarter would rather owe the supplier more in six months than fail to pay the electricity bill this week. The trade is the same one position 3 made: more owed later, in exchange for less to find now. Payment in kind is that trade written into a loan agreement, priced, and signed by both sides.

Why would a lender agree to it?

Because the price of waiting is a higher rate, and because the alternative to agreeing is often a conversation nobody wants. When the two rates on position 3 moved from eleven and five to eight and nine, the total contracted rate went from sixteen per cent to seventeen per cent. The lender is now charging a point more a year on this loan. The cash coupon fell from Rs 3,30,00,000 to Rs 2,40,00,000, so the lender is also collecting Rs 90,00,000 a year less in cash than it was.

The same three lines of a document are a cash concession from one side of the table and a rate increase from the other, and which of the two it looks like depends entirely on which number is read. Which of the two readings is the right one, and whether the trade was good for anybody, are judgements of a different kind. Both readings are simply true, and a reader who can only see one of them will be surprised by the other later.

How far did the cash share of income actually fall?

From 68.8 per cent to 47.1 per cent in a single step, and then to 44.9 per cent the year after. Here is the whole of that arithmetic on one loan, and it is worth working through slowly because every figure in it has already appeared somewhere above.

Read the last two columns against each other. They move in opposite directions, and that is the entire lesson. Income rose from Rs 4,80,00,000 to Rs 5,10,00,000 while the share of it arriving as money fell by more than twenty points, and both of those happened because of the same clause on the same day. A lender reading only the income column has seen a better year. A lender reading only the cash column has seen a worse one. Neither has read the loan.

The second step is smaller and it is worth being honest about the size. Between year one and year two the share slips 2.1 points further, from 47.1 to 44.9, and on a scale that runs from zero to a hundred that slip is nearly invisible. The slip should look small, and it is small. The direction matters more than the size: the share points downwards and keeps pointing downwards for as long as the cash side is pinned and the accruing side is not.

What happens when two years of recognised income are added together?

What is worth asking of a fund's income line?

More people read a lender's report than ever negotiate a loan document, and that is where the subject earns its keep. An investor in a credit fund, an analyst covering one, a student handed an annual statement and a person on an investment committee all meet the same line: interest income, one number, no split. Three questions turn that line back into something that can be reasoned about, and none of them needs any figure the report does not already carry.

First, ask how much of the interest income was received in cash. Not how much was due, not how much was recognised: how much arrived. On position 3 in the first year after the reset the answer is Rs 2,40,00,000 out of Rs 5,10,00,000. A lender that cannot answer that question for its own book cannot say what its income is made of, and a reader who never asks it will treat every rupee of recognised income as though it were spendable.

Second, ask what the balances are doing while that income is recorded. Rising principal on a loan nobody has topped up is the signature of interest being capitalised, and it is visible without anyone explaining it: Rs 30,00,00,000 becomes Rs 32,70,00,000 becomes Rs 35,64,30,000 with no new money lent. Third, ask what the coupon is charged on, both halves of it. The two bases above show why: two loans quoting the same eight and nine produce different cash and different shares depending on that one convention.

What one sentence belongs beside every payment-in-kind rate?

The lender recognises income it has not received in cash. The sentence is short, and it belongs in the same breath as the rate rather than in a note underneath. A payment-in-kind rate quoted on its own states half a fact, and the missing half is the one that decides whether anything can be spent.

Being precise about what that sentence does not say is worth a moment. The sentence does not say the accrued amount will not be paid. Nor does it say the loan is in trouble, or that this structure is worse than another, or that anybody should have done something differently. The claim is only that the income and the cash are two numbers, that on position 3 they were Rs 5,10,00,000 and Rs 2,40,00,000, and that anybody reading the first without the second has read the loan wrong. Whether the balance is eventually repaid is a question about a borrower, answered by a separate discipline.