As I look back on 2024, I witness an extreme growth in private equity investments and I continue to be reminded of bubbles throughout history where individuals continue to purchase investments at ever increasing prices. There’s a few red flags associated with private equity and private credit investments such as a lack of mark to market accounting. Additionally a common occurrence of payment in kind (PIK) rather than payments in cash which I will discuss in detail today.
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Payment in Kind refers to a method of paying interest or dividends or other compensation in the form of additional securities instead of cash. In private equity investments, PIK is often used as a way to defer cash payments or to provide flexibility to the company in terms of its cash flow management.
For example, a private equity investment might issue a PIK loan with a 10% annual interest rate. Instead of paying $10 million in interest in cash each year, the company would issue additional debt worth $10 million (e.g., more bonds) to you, the investor. This increases the company’s total debt obligation, but it doesn’t require the company to use cash to make interest payments, which might be important if the company is struggling with liquidity or wants to preserve cash for growth initiatives.
Another example in the case of PIK preferred equity, the company may issue preferred equity securities that pay dividends in kind. Instead of paying cash dividends to preferred shareholders, the company issues additional preferred shares.
After reading a few annual reports of private equity investments I have found many fund managers utilizing PIKs rather than payments in cash for dividends. Why do most people purchase investments? It’s to receive future cash flows and ideally dividend payments or buybacks from a company that an investor owns. Another downside that is often not discussed is the continual issuance of shares by the fund manager to make these PIKs. So as a shareholder your ownership interest in the business is being diluted and you are being paid “dividends” in the form of shares that are worth less than you originally purchased them for.
After reviewing a private equity investment that invests in NNN properties I found that the investment managers pay rather substantial fees to investment advisors that sell the private equity investment. Ironically, the fund managers are paying the sales agents in PIKs instead of cash. Remember those shares that are being given to sales agents are a fraction of your ownership interest in the investment. Additionally the credit quality of the actual NNN tenants is decreasing and late payments of rent are rising. In essence you are owning less and less of an asset that is deteriorating in earnings power.
I’m not sure when the party will end but I am certain that it will end badly. Hopefully my thoughts here can help you make better investment decisions for yourself and your family in 2025.
Jason Rager serves as a Board Member of Green Stack Capital a NNN real estate investment company located in Wilmington Delaware. Mr. Rager is a graduate of Babson College and has decades of investment and asset allocation experience. He often writes about inflection points in the investment, interest rate, and business cycle.
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