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)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 based on 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 - or a Senior Note - 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 (also known as junior debt), because senior debt is usually collateralized by assets, and senior debtholders are paid first. 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 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 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.
Other Resources
CFI offers the Certified Banking & Credit Analyst (CBCA)™CBCA™ CertificationThe Certified Banking & Credit Analyst (CBCA)™ accreditation is a global standard for credit analysts that covers finance, accounting, credit analysis, cash flow analysis, covenant modeling, loan repayments, and more. certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
- 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. 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 based on 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.
