What is a PIK 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) transactions.
Depending on the case, the payment of interest may be made by issuing another debt or by the issuance of stock options. Upon maturity or refinancing of the loan, the total amount of the original loan plus the PIK debt 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 interest, 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 investing in a PIK loan offers a high rate of return, it is also very 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 debt and mezzanine debt, and they are generally not backed by a pledge of 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 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 them.
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