What is a PIK Loan?
A payment-in-kind (PIK) loan is a loan characterized by the fact that the payment of interestInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also be calculated through the debt schedule. The schedule should outline all the major pieces of debt a company has on its balance sheet, and calculate interest by multiplying the is not always made in cashCash EquivalentsCash and cash equivalents are the most liquid of all assets on the balance sheet. Cash equivalents include money market securities, Bankers Acceptances, Treasury bills, commercial paper, and other money market instruments.. 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 loan term is ended. PIK loans are more 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
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 based on its maturity and interest rate. In financial modeling, interest expense flows into the income statement, closing debt balance flows onto the balance sheet, principal repayments flow through the cash flow statement, completing the scheudle, such as during a managementManagement Buyout (MBO)A management buyout (MBO) is a corporate finance transaction where the management team of an operating company acquires the business by borrowing money to buy out the current owner(s). This transaction is a type of leveraged buyout (LBO) and can sometimes be referred to as a leveraged management buyout (LMBO). 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
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 debtSenior DebtSenior Debt or a Senior Note is money owed by a company that has first claims on a company’s cash flows. It is more secure than any other debt such as subordinated debt (also known as junior debt) because senior debt is usually collateralized by assets. This means the lender is granted a first lien claim 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; and they are generally not based 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 trancheBond TranchesBond tranches are usually portions of mortgage-backed-securities that are offered at the same time and usually carry different risks, 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 risks 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 risksMarket Risk PremiumThe market risk premium is the additional return an investor will receive (or expects to receive) from holding a risky market portfolio instead of risk-free assets. The market risk premium is part of the Capital Asset Pricing Model (CAPM) which analysts and investors use to calculate the acceptable rate involved. Companies must successfully weigh the benefits of the investment vis-à-vis the cost of obtaining same.
To learn more about debt financing, check out the following CFI resources.
Other Resources:
- Poison Pill
- 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
- 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 limit. The borrower can access any amount up to this limit at any time and does not have a specific term to pay the loan back.
- Revolving DebtWhat is Revolving Debt - Guide and ExplanationRevolving debt is a line of credit individuals and corporations can borrow from and pay back as needed. Revolving debt does not deplete like regular loans. A revolving debt does not have a fixed amount of payment every month. The charges are based on the actual balance of the loan.
