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FRM Part II · FRM Exam Part II · Private Markets Investing

A private credit fund holds a loan with a PIK toggle that the borrower has recently elected to pay in kind rather than in cash. From a risk management perspective, what is the most appropriate interpretation?

Electing PIK is a possible early warning of borrower liquidity stress. Interest accrues to principal instead of being paid, so reported income rises while cash received falls and the borrower's debt and leverage increase, raising the loss risk on the loan.

  1. AA positive signal, because accrued income increases reported returns with no additional risk
  2. BNeutral, because PIK interest is economically identical to cash interest in all cases
  3. CA potential early warning of borrower liquidity stress, since reported income rises while cash collected falls and leverage growsCorrect
  4. DA reduction in credit risk, because the principal balance is amortizing faster

Explanation

PIK capitalizes interest into principal, increasing debt and loan-to-value while no cash is received. Electing it often signals cash flow strain, so reported income overstates cash performance. It does not amortize principal.

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