What is a PIK loan?
A payment-in-kind (PIK) loan is a loan characterized by the fact that the payment of interest is not always made in cash. Instead, interest can be paid by a borrower in a deferred manner via the issuance of additional securities in lieu of paying interest in cash. The PIK loan enables the debtor to borrow without having the burden of a cash repayment of interest until the end of the loan. PIK loans are more commonly used in leveraged buyout (LBO) 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
PIK loans are taken if a company has a liquidity problem, but then 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 interest, such as during a management or leveraged buyout, or during a growth phase of the business. In order to protect their own liquid assets, companies pay their liabilities with the help of new liabilities.
Risks
Though this type of credit has high growth potential, it is also very expensive and risky. Its interest is higher than other loans which is charged on a compound basis. PIK loans do not generate any cash flow before term; they are subordinated to conventional debt and mezzanine debt; and they are generally not bought on 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 do not have 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 tranche 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 same.