PIK Tricks: 10 things for lenders to think about when capitalizing interest

4 minute read
26 March 2020

In the current environment, lenders and banks may wish to be supportive of their borrower clients who are looking to protect cash flow. One way of doing that might be to allow the borrower to capitalize interest (also referred to as Payment-In-Kind or PIK) for a period of time. Here are ten things to think about when considering a PIK arrangement.

  • Dollar limits

If any security (guarantees, mortgages, hypothecs or otherwise) is dollar limited, then as principal debt increases, ensure that such limits are increased appropriately. In any case guarantors should acknowledge the change to the credit.

  • Financial covenants

Financial covenants may have to be adjusted. A Debt to EBITDA covenant, for example, may have to be relaxed as principal debt increases.

  • The taxman cometh

Simple interest is deductible to the borrower. Interest on capitalized interest is not. This could cause a delayed cash flow problem to the borrower when taxes are due that needs to be considered.

  • Maturities and clean-downs

As maturity dates and required clean-down dates, if any, approach, a PIK could mean more stress on the borrower to come up with additional cash for payment.

  • Criminal rate

Capitalized interest and compound interest may both be considered interest for the purpose of calculating interest under the Criminal Code of Canada. Although unlikely, consider if capitalization creates a criminal interest rate.

  • Third party covenants

The borrower may be subject to other third party debt covenants that would be breached by increasing principal debt. Ensure that they have done their own due diligence to avoid cross defaults to those third party covenants and ensure your own review of known material contracts that could have such cross defaults.

  • Construction facilities

Unclear case law may create pitfalls where loans are secured by mortgages and construction or real estate improvement is known to be in progress. Maintain searches at dates of capitalization to ensure no loss of priority.

  • Reporting

Consider that PIK arrangements likely reflect adjustments to assist the borrower with a stressed cash flow situation. Reporting may have to be equivalently adjusted, for example to the provision of 13 week cash flows, to ensure that the situation is not degrading.

  • An alternative interest adjustment

If the borrower's capital structure does not allow for capitalization of interest, whether in full or in part, consider interest accrual as an alternative.

  • Traded loans

If the debt is traded, match interest periods with capitalization for ease of liquidity.

Christopher Alam is the Lending National Practice Group Leader at Gowling WLG.

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