- PIK (Payment-in-Kind) Loan
- Advantages of PIK Loans
- Risks of PIK Loans
- In a Nutshell
- Other Resources
- Payment in Kind Bonds
- What is a Payment-In-Kind Bond?
- Features of Payment in Kind Bonds
- Maturity Period
- Unsecured Debt
- No Refinancing
- Detachable Warrant
- Types of Payment in Kind Bonds
- Payment in kind bonds toggle or pay if you
- Pay if you can
- True payment in kind bonds
- Holdco PIK bonds
- Why Should One Accept Payment in Kind Bonds?
- Risks of Payment in Kind Bonds
- Payment in Kind Bond
- Features of PIK or Payment in Kind
- What are the reasons for taking Payment In-Kind?
- Increased leverage
- Cash-out events
- Suitable for companies with the long operating cycle
- Types of Payment in Kind
- #1 – True PIK
- #2 – Pay if you can
- #3 – Holdco PIKs
- #4 – Pay if you / PIK toggle
- PIK Toggle Examples
- PIK in Leveraged Buyout
- How is Payment in Kind beneficial to lenders or financiers?
- PIKs rank high on underlying risk
- Recommended Articles
PIK (Payment-in-Kind) Loan
A payment-in-kind or PIK loan is a loan where the borrower is allowed to make interest payments in forms other than cash. The PIK loan enables the debtor to borrow without having the burden of a cash repayment of interest until the loan term is ended.
PIK loans are commonly used in leveraged buyout (LBO)Leveraged Buyout (LBO)A leveraged buyout (LBO) is a transaction where a business is acquired using debt as the main source of consideration.
An LBO transaction typically occur when a private equity (PE) firm borrows as much as they can from a variety of lenders (up to 70-80% of the purchase price) to achieve an internal rate return IRR >20% transactions.
Depending on the case, the payment of interest may be made by another debt security by the borrowing of a company’s securities or by the issuance of stock options. Upon maturity or refinancing of the loan, the total amount of the original loan plus the PIK notes issued in lieu of interest is repaid.
Advantages of PIK Loans
PIK loans are taken if a company has a liquidity problem, but has the capability to pay interest without paying in cash form.
This is attractive to companies that want to avoid making current cash outlays for debt interestDebt ScheduleA debt schedule lays out all of the debt a business has in a schedule its maturity and interest rate.
In financial modeling, interest expense flows such as during a management or leveraged buyout or during a growth phase of the business. In order to protect their liquid assets, companies pay their liabilities with the help of new liabilities.
Risks of PIK Loans
Though a PIK loan offers high growth potential, it is also very expensive and risky. Its interest is higher than other loans that are charged on a compound basis. The loans do not generate any cash flow before term.
They are subordinated to conventional debtSenior DebtSenior Debt is money owed by a company that has first claims on the company’s cash flows.
It is more secure than any other debt, such as subordinated debt and mezzanine debtMezzanine FundA mezzanine fund is a pool of capital which invests in mezzanine finance for acquisitions, growth, recapitalization, or management/leveraged buyouts.
In the capital structure of a company, mezzanine finance is a hybrid between equity and debt. Mezzanine financing most commonly takes the form of preferred stock or subordinated and unsecured debt., and they are generally not assets. In addition, PIK loans are usually treated as unsecured credit. They tend to lead to large losses in the event of a default.
In a Nutshell
Payment-in-kind loans are usually issued by companies in poor financial condition that lack the cash to pay interest. They are undertaken by investors that do not depend on the routine cash flow of the borrower as the repayment source of their investments.
From a borrower’s perspective, PIK loans may be utilized as a trancheBond TranchesBond tranches are usually portions of mortgage-backed-securities that are offered at the same time and that typically carry different risk levels, rewards, and maturities.
For example, collateralized mortgage obligations (CMO) are structured with a number of tranches that mature on different dates, carry varying levels of risk, and pay different interest rates. or part of a bigger funding package to fund acquisitions and leveraged buyouts in general.
However, it must be noted that it is fraught with risk and very high interest rates.
PIK loans will either provide a company with the cash needed to recover or simply aggravate the situation and multiply the risks involved. Companies must successfully weigh the benefits of the investment vis-à-vis the cost of obtaining them.
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- Mezzanine FundsMezzanine FundA mezzanine fund is a pool of capital which invests in mezzanine finance for acquisitions, growth, recapitalization, or management/leveraged buyouts. In the capital structure of a company, mezzanine finance is a hybrid between equity and debt. Mezzanine financing most commonly takes the form of preferred stock or subordinated and unsecured debt.
- Revolver DebtRevolver DebtRevolver debt is a form of credit that differs from installment loans. In revolver debt, the borrower has constant credit access up to the maximum
- Revolving DebtWhat is Revolving Debt — Guide and ExplanationRevolving debt is also referred to as a line of credit (LOC). A revolving debt does not have a fixed payment amount every month. The charges are the actual balance of the loan. The same is true for the computation of the interest rate; it is dependent on the total outstanding balance of the loan.
Payment in Kind Bonds
Payment in Kind Bond is a financial debt instrument issued by the company to acquire funds from the investors.
A company has different types of structure for its capital to suit its debt-equity levels at different points during the business cycles. For acquiring finance, a company has to plan how to pay interest on the same as well.
Payment in kind (PIK) bonds is one such debt structure in which a company pays interest to the lenders/investors by issuing extra bonds. The extra issue can be a mix of both cash and other debt instruments.
Issued in place of cash interest payments, it is also regarded as deferred coupon bonds.
What is a Payment-In-Kind Bond?
In a payment in kind bond, the borrowing company has to pay interest in the form of further bonds or preferred stocks. The concept behind this debt structure relies on the fact that the interest capitalizes over time.
Then the accrued interest is paid in the form of other debt instruments on which the investor can earn money in the form of interest or dividends. The interest on payment in kind bonds is referred to as the coupon rate which is a terminology of fixed income.
The investors are paid coupon payments half-yearly as return on investment.
Example: An investor invested INR 10,000 on payment in kind bonds by buying 10 such bonds of face value INR 1000 which pays 5% interest. Then his return on investment would be
= ½ x 5% x INR 1000 x 10
= INR 250, to be paid twice a year. So, his yearly ROI would be INR 500.
Features of Payment in Kind Bonds
The characteristics of payment in kind bonds are as follows –
These bonds come with a maturity period of more than five years. It depends on the company for how long they want to issue the bond.
These bonds are an unsecured form of debt due to lack of an underlying asset. There is no collateral or mortgage attached to these bonds.
In the first few years, there cannot be any form of refinancing done on this debt. Even if it is allowed the cost for the same is too high.
There is a detachable warrant which is issued with these bonds which provides certain rights to the investors to have a share of the profit of the business. With the warrant, the investor can purchase equity shares/bonds of the company which will give the investor a share of profit.
Types of Payment in Kind Bonds
There are different types of payment- in -kind bonds discussed as below –
Payment in kind bonds toggle or pay if you
In this type of PIK bonds, the borrowing company can defer the payment of interest by issuing additional bonds. It can finally pay after the bond matures.
It is the discretion of the company whether to pay the interest periodically or on maturity in the form of cash or otherwise. The issuer has to inform the bondholder of this allotment at least 6 months before the payment date.
For interest payment is done after maturity, the rate is much higher than the actual rate of interest.
Pay if you can
Here the bond issuing company has to pay the interest amount in cash if some of the criteria for restricted payment are fulfilled. If not, then they can pay in kind which attracts a higher interest rate on final maturity.
True payment in kind bonds
This is a plain vanilla payment in kind bonds which has the obligation to pay interest in kind – at least a part of it. It is a compulsion for the company issuing the bonds.
Holdco PIK bonds
It is a subordinated type of bonds on which interest can be paid in cash if there is a residual cash stream available.
Why Should One Accept Payment in Kind Bonds?
The investors of payment in kind bonds have the certainty to get their return on their investment. These bonds will pay the interest accrued on it – periodically or after maturity. Cash interests are not certain all the time and thus PIK is a good way to fix your return on investment.
People, who invest in private equities, often prefer these bonds as they want to preserve their return on investment. These bonds provide another debt instrument as interest regarded as an addition to an investors profile without any further investment. This increases the overall return of the investor over a span of time.
An investor would be most keen on such an arrangement if the growth trajectory of the company is high.
Also, see what other kinds of bonds offer and their features.
Risks of Payment in Kind Bonds
The payment in kind bonds comes with an additional credit risk. It is because the lender has to forego the cash interest at that point in time.
Credit risk uncertainty remains in the business environment for which the borrower compensates the lender with a higher and profitable interest rate.
Moreover, there is no underlying security/collateral safeguarding the interest of the investor. The bondholders get paid before the shareholders when the company liquidates.
Thus, payment in kind bonds is a boon for a well-established company in a cash crunch. One wich is unable to pay interest in cash right away.
It is at their discretion to pay the interest on this debt which makes this instrument favorable from the company’s point of view.
Even with such high risks, the demand for the bond remains high due to the high-interest payment and return on investment from the investor’s point in view.
Last updated on : August 25th, 2018
Payment in Kind Bond
Where interest is paid off by the issuer of a bond via additional bonds issue instead of cash payment, it is known as payment in kind bond, thus no interest is paid until maturity of the bond and total interest is paid at the time of maturity and hence it lessens the cash payment burden of the issuer of debt or bonds.
The Capital structure of a company is nothing short of a chequered board. Various modes of financing are available to suit the situation as well as the requirement of the companies.
We all know that a simple debt structure involves procuring finances followed by subsequent payment of interest and principal on pre-determined dates. However, when it comes to corporate financing, this has many more layers added to it.
Companies usually plan to design a structure that is easy on the cash flows, tax-efficient, and flexible enough to factor in unforeseen events. One such debt structure is called “Payment-in-Kind” or PIK.
PIK bond is the one on which the borrowing company pays no cash interest until the total principal is repaid or redeemed. Instead of this, on each interest payment due date, the accrued interest is capitalized.
It may either be added to the principal amount or maybe ‘’paid’’ through the issuance of further loan notes, bonds, or preferred stocks with interest or dividends paid in securities. In fact, this is how it derives its name, which means the payment of interest can be made through instruments other than cash.
It is to be noted that the securities used to settle the interest or dividends are generally identical to the underlying securities, but on many occasions, they have different terms.
Going back to the basics, payment in kind is nothing but a form of Mezzanine debt. Mezzanine debt is the intermediate layer of capital that features between secured senior debt and equity.
This is a capital that is generally not secured by assets and is primarily disbursed depending on a borrower’s (company’s) ability to repay the debt from free cash flow.
Mezzanine financing is usually more expensive than senior debt; however, it is less expensive than equity.
Let us understand Payment in Kind in a simpler way: Assume a company takes a mezzanine loan for $20 million with a 15% in current cash interest and 4% in PIK interest, without warrants and with the due date of note in 5 years’ time.
After a year’s time, the current interest, $3 million, is paid in cash as per the terms of the deal, while the PIK interest of $800,000 is paid in security and is accumulated to the principal amount of the note, increasing that amount to $20.8 million.
This continues to be compounded till the end of the fifth year when the lender will receive the Payment in Kind interest in cash when the note is paid at maturity.
Features of PIK or Payment in Kind
The main features of a PIK or Payment-in-Kind debt are:
|Unsecured||These loans are typically unsecured, i.e., they are not backed by any kind of pledge of assets as collateral|
|Maturities||The maturity of the Payment-in-Kind debt usually exceeds 5 years|
|Hybrid Security||This loan comes with a detachable warrant, which implies having the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time, or any kind of similar mechanism which facilitates the lender to have a share in the prospective success of the business.|
|Restricted refinancing||Refinancing of Payment in Kind loans is usually restricted in the initial years. In case it is allowed, it comes at a high premium|
What are the reasons for taking Payment In-Kind?
We know that most companies opt for Payment in Kind due to the certain liberties it provides. Let us dig further to understand the detailed reasons to include Payment-in-Kind (PIK) debt in a leveraged capital structure.
This debt instrument augments the borrowing capacity of a company, allowing them to leverage their capital structure without creating too much pressure on their cash flow.
Payment in Kind debt gives the borrower a greater deal of flexibility as compared to other debt instruments. This further enables them to protect cash for other capital expenditures, inorganic growth, or acquisitions or to hedge against the possible downturns in the business cycle.
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Many times, PIK is used before a cash-out event (for example, an IPO or liquidation) in order to anticipate and lock-in cash realizations and protect ‘’upside’’ for the equity sponsor at the same time.
Suitable for companies with the long operating cycle
For companies that are usually cash-strapped and have long gestation cycles for their products, Payment in Kind seems to be the most suitable form of financing. They have the opportunity to scale up their operations with additional financing but with minimal cash outflow.
Types of Payment in Kind
Payment in Kind manifests itself in various forms. While the underlying concept remains the same, there are minor variations according to the situation and the financing goal. Some of the popularly used forms are:
#1 – True PIK
The obligation to pay interest (or a portion of the interest) in kind is compulsory and is predefined in terms of the debt. This is actually the plain vanilla kind of PIK.
#2 – Pay if you can
The borrower (or issuer) is supposed to pay interest in cash if certain restricted payment criteria are met.
If the prescribed conditions are not fulfilled due to situations such as senior debt restrictions preventing the borrower (or issuer) from gaining sufficient funds from its operating subsidiaries), then interest is payable in kind, usually at a rate higher than payment in cash.
Although these PIK structures cannot avoid the prevailing restrictions or payment test, their compulsory cash-pay nature lowers the financial flexibility and liquidity for issuers.
#3 – Holdco PIKs
Certain PIKs have the added risk of being issued at the holding company level, which means that they are “structurally” subordinated and depend solely on the residual stream of cash, if any, from the operating company to service them.
#4 – Pay if you / PIK toggle
The borrower (or issuer) can exercise its discretion to pay interest for any given period in cash, in-kind, or in a combination of both of them.
PIK toggle notes were quite prevalent in leveraged capital structures before the financial crisis in 2008. When Leveraged Buyout (LBO) was at its peak in 2006, the PIK-toggle structure was the biggest innovation.
Usually, the issuer is supposed to inform investors six months in advance before “flipping the switch.” These “PIK toggle” securities empower borrowers to make a choice.
They can continue to pay interest on a bond, or they can defer the payment until the bond matures, and in the process, settle for an interest rate that is quite higher than the original rate.
PIK-toggle note issuance reached about $12 billion in 2013 – the highest level since the credit crisis in 2008 – however it was just 4% of total supply, as compared to 14% in 2008. Most of them backed dividend with a few financing ones.
Only one was LBO oriented. Though the U.S. high yield bond market came off from the risk-off period of late 2015/early 2016, that was only to an extent.
There has been almost nominal or no PIK/PIK toggle issuance since the second quarter of 2015
PIK Toggle Examples
Neiman Marcus pioneered the trend for PIK Toggle bonds way back in 2005 when it was first bought out by Warburg Pincus and Texas Pacific Group. It is believed that TPG was quite worried as to what would happen if the retailer Neiman Marcus had to weather sudden economic downturn or losses due to wrong corporate policies.
It then dawned on them to design an unusual structure where some of the debt it put on Neiman Marcus would be utilized to finance the acquisition. If the retailer witnessed unexpected headwinds, it could stop paying cash interest on the $700 million in debt, and instead, pay back a higher sum when the bonds matured in 2015.
Some of the other instances of PIK Toggle were:
It was a deja-vu moment for Neiman Marcus when its new owners, Ares Management and Canadian Pension Plan Investment Fund, in October 2013, issued a US$600 million PIK toggle to partly-finance their US$6 billion buyouts.
Source: Standard & Poor’s/ WSJ
Experts are divided on the opinion about the effectiveness or practicality of the PIK Toggle debt.
Advocates say that the high-interest rates attached to PIK toggle notes give borrowers a motivation to continue making interest payments unless any kind of financial pressure comes up.
However, on the other hand, S&P’s Leveraged Commentary & Data Group once opined that PIK toggle bonds have an underlying risk quotient because they have the potential to burden investors with more debt in financially-struggling companies and limited cash from them.
PIK in Leveraged Buyout
In leveraged buy-outs, a PIK loan is used if the purchase price of the target is more than the leverage levels up to which lenders agree to provide a senior loan, a second lien loan, or a mezzanine loan, or if there is the limited cash flow available to make payments of a loan (i. e. due to dividend or any merger-related restrictions). It is not provided to the target itself. Usually, it is the acquisition vehicle, another company, or a special purpose entity (SPE) that receives the loan.
As a practice, PIK loans in leveraged buy-outs carry a considerably higher interest and fee burden than the senior loans, second lien loans, or mezzanine loans of the same transaction. With yields higher than 20% per annum, the acquirer has to do a prudent assessment that the cost of taking a PIK loan should not exceed his internal rate of return of equity investment.
In July 2004, the leveraged buyout firm KKR refinanced its acquisition of Sealy Mattress Company with subordinated pay-in-kind (PIK) notes worth $75.0 million principal amount.
How is Payment in Kind beneficial to lenders or financiers?
Lenders structure their loans with a PIK interest component when they want to enhance the certainty of their investment return.
For instance, when the lenders differ with equity research or portfolio management companies on the future value of equity, they may prefer receiving cash interest and Payment in Kind interest instead of cash interest and warrants to purchase equity.
The value of a warrant, upon exit, becomes uncertain. Thus the contractually certain, compounded PIK return appears more appealing.
For a mezzanine or private equity investor, PIK is most often the most suitable strategy whenever one wants to “lock-in” an investment return.
In fact, these lenders prefer the PIK feature because not only do they receive new security in the portfolio company without deploying any additional cash, but it results in a compounded interest effect, which in turn increases the overall investment return.
PIKs rank high on underlying risk
The position of PIK debt is usually after other debt in a financing structure, which has a cash pay interest option. Servicing the debt with interest in kind rather than in cash comes at a premium – PIK interest is naturally higher than cash interest.
This is done to compensate lenders (or investors) for relinquishing their option to receive their cash-pay interest throughout the tenure of the debt. In fact, the lenders have to take on additional credit risk by increasing the amount of principal they are due to receive as the interest keeps accumulating.
However, the interest is compounded annually, gives a compound return.