PIK loan
Encyclopedia
A PIK loan is a type of loan
which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity
or refinancing
date, not even interest or parts thereof (see mezzanine loan), thus making it an expensive, high-risk financing instrument. PIK (payment in kind) is to be interpreted as interest accruing until maturity or refinancing.
PIK loans are typically unsecured (i.e. not backed by a pledging of assets) or with a deeply subordinated security structure (e.g., third lien). Maturities usually exceed five years and in a standard offer, the loan carries a detachable warrant
(the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) or a similar mechanism to allow the lender to share in the future success of the business, making it a hybrid security
.
, which can come from three major sources: arrangement fee, PIK, and warrants. There are also minor sources, like a ticking fee. The arrangement fee, usually payable up-front, contributes the least return and is more aimed to cover administrative costs. PIK is interest accruing period after period, thus increasing the underlying principal (i.e., compound interest). The achieved selling price of the shares acquired under the warrant is also a part of the total return of the lender. Typically, refinancing of a PIK loan in the first years is either completely restricted or comes at a high premium (i.e. prepayment protection) to suit internal requirements of investing funds.
Interest on PIK loans is substantially higher than debt of higher priority, thus making the compound interest the dominating part of the repayable principle. In addition, PIK loans typically carry substantial refinancing risk
, meaning that the cash flow
of the borrower in the repayment period will usually not suffice to repay all monies owed if the company does not perform excellently. By that definition, PIK lenders prefer borrowers with strong growth potential. Because of the flexibility of the loan, also in the long term, there are basically no limits to structures and borrowers. Plus, in most jurisdictions the accruing interest is tax deductible, providing the borrower with a substantial tax shield
.
In some cases, cash payment or PIK is at the discretion of the borrower; in other cases, it is determined by a cash flow trigger. These are sometimes derisively referred to as PIYW (“Pay If You Want”) and PIYC (“Pay If You Can”).
levels up to which lenders are willing to provide a senior loan, a second lien loan
, or a mezzanine loan, or if there is no cash flow available to service a loan (i. e. due to dividend
or merger restrictions). It is typically provided to the acquisition vehicle, either another company or a special purpose entity
(SPE), and not to the target itself.
PIK loans in leveraged buy-outs typically carry a substantially higher interest and fee
burden than do senior loans, second lien loans, or mezzanine loans of the same transaction. With yield
exceeding 20% per annum, the acquirer has to be very diligent in assessing whether the cost of taking out a PIK loan does not outbalance his internal rate of return
of equity investment.
Before the credit crunch of Summer 2008, several LBOs have seen some secured second-lien term bank loans coming with PIK or, more frequently, PIK toggle features, in order to support the firm's ability to cover cash interest during the initial period after the LBO. If the acquired company performs well, the PIK toggle feature allows the equity sponsor to avoid giving extraordinary returns to the PIK debt, which might happen if the debt were strictly PIK. Since the credit crunch, the PIK toggle has largely disappeared.
, when a bond
pays in kind (PIK), it means that the interest on the bond is paid other than in cash. The most common form of this is for the principal owed to the bondholder to be increased by the amount of current interest
. Other forms of PIK arrangements are also found, such as paying (transferring to) the bondholder an amount of stock (in the company issuing the bond or in another, typically related, company) with value equal to the current interest due.
Often such arrangements are referred to by the acronym PIK. Most bonds pay cash, not in kind, coupons.
PIK can be used as a verb (e.g. the bond "PIKed") or an adjective (e.g. that bond is "PIKable"). Where a previously PIKed amount is revoked (as is permissible in some agreements), this is known as "unPIKing".
in 2005. Glazer used PIK loans, which were sold to hedge funds, to fund the takeover, much to the displeasure of many of the club’s supporters, because the burden of the debt was placed on the club itself, not the Glazers.
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
or refinancing
Refinancing
Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic factors such as, inherent risk, projected risk, political...
date, not even interest or parts thereof (see mezzanine loan), thus making it an expensive, high-risk financing instrument. PIK (payment in kind) is to be interpreted as interest accruing until maturity or refinancing.
PIK loans are typically unsecured (i.e. not backed by a pledging of assets) or with a deeply subordinated security structure (e.g., third lien). Maturities usually exceed five years and in a standard offer, the loan carries a detachable warrant
Warrant (finance)
In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date....
(the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) or a similar mechanism to allow the lender to share in the future success of the business, making it a hybrid security
Hybrid security
Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity.Hybrid securities pay a predictable rate of return or dividend until a certain date, at which point the holder has a number of options including converting the...
.
Return and Interest
PIK lenders, typically special funds, look for a certain minimum internal rate of returnInternal rate of return
The internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
, which can come from three major sources: arrangement fee, PIK, and warrants. There are also minor sources, like a ticking fee. The arrangement fee, usually payable up-front, contributes the least return and is more aimed to cover administrative costs. PIK is interest accruing period after period, thus increasing the underlying principal (i.e., compound interest). The achieved selling price of the shares acquired under the warrant is also a part of the total return of the lender. Typically, refinancing of a PIK loan in the first years is either completely restricted or comes at a high premium (i.e. prepayment protection) to suit internal requirements of investing funds.
Interest on PIK loans is substantially higher than debt of higher priority, thus making the compound interest the dominating part of the repayable principle. In addition, PIK loans typically carry substantial refinancing risk
Refinancing risk
In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing debt. Many types of commercial lending incorporate balloon payments at the point of final maturity; often, the intention or assumption is that the borrower will take out a new...
, meaning that the cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
of the borrower in the repayment period will usually not suffice to repay all monies owed if the company does not perform excellently. By that definition, PIK lenders prefer borrowers with strong growth potential. Because of the flexibility of the loan, also in the long term, there are basically no limits to structures and borrowers. Plus, in most jurisdictions the accruing interest is tax deductible, providing the borrower with a substantial tax shield
Tax shield
A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield...
.
PIK toggles
With a PIK toggle note, the borrower in each interest period has the option to pay interest in cash or to PIK the interest payment. Sometimes, the borrower may also be able to PIK some portion of the interest (usually half) while paying the rest in cash; at times, only some of the interest may be paid in kind and the rest is cash-only. This feature allows the issuers to reduce cash interest payments for a period if necessary. The documentation often provides that if the PIK feature is activated, the interest rate is increased by 25, 50 or 75 basis points.In some cases, cash payment or PIK is at the discretion of the borrower; in other cases, it is determined by a cash flow trigger. These are sometimes derisively referred to as PIYW (“Pay If You Want”) and PIYC (“Pay If You Can”).
Leveraged buy-outs
In leveraged buy-outs, a PIK loan is used if the purchase price of the target exceeds leverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
levels up to which lenders are willing to provide a senior loan, a second lien loan
Second lien loan
Second lien loan is a form of loan with a security interest in the assets of a company that are second in ranking behind a traditional senior credit facility...
, or a mezzanine loan, or if there is no cash flow available to service a loan (i. e. due to dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
or merger restrictions). It is typically provided to the acquisition vehicle, either another company or a special purpose entity
Special purpose entity
A special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives...
(SPE), and not to the target itself.
PIK loans in leveraged buy-outs typically carry a substantially higher interest and fee
Fee
A fee is the price one pays as remuneration for services. Fees usually allow for overhead, wages, costs, and markup.Traditionally, professionals in Great Britain received a fee in contradistinction to a payment, salary, or wage, and would often use guineas rather than pounds as units of account...
burden than do senior loans, second lien loans, or mezzanine loans of the same transaction. With yield
Yield (finance)
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return...
exceeding 20% per annum, the acquirer has to be very diligent in assessing whether the cost of taking out a PIK loan does not outbalance his internal rate of return
Internal rate of return
The internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
of equity investment.
Before the credit crunch of Summer 2008, several LBOs have seen some secured second-lien term bank loans coming with PIK or, more frequently, PIK toggle features, in order to support the firm's ability to cover cash interest during the initial period after the LBO. If the acquired company performs well, the PIK toggle feature allows the equity sponsor to avoid giving extraordinary returns to the PIK debt, which might happen if the debt were strictly PIK. Since the credit crunch, the PIK toggle has largely disappeared.
PIK bonds
In modern financeFinance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, when a bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
pays in kind (PIK), it means that the interest on the bond is paid other than in cash. The most common form of this is for the principal owed to the bondholder to be increased by the amount of current interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
. Other forms of PIK arrangements are also found, such as paying (transferring to) the bondholder an amount of stock (in the company issuing the bond or in another, typically related, company) with value equal to the current interest due.
Often such arrangements are referred to by the acronym PIK. Most bonds pay cash, not in kind, coupons.
PIK can be used as a verb (e.g. the bond "PIKed") or an adjective (e.g. that bond is "PIKable"). Where a previously PIKed amount is revoked (as is permissible in some agreements), this is known as "unPIKing".
Examples
One high profile use of PIKs involved the controversial takeover of Manchester United Football Club in England by Malcolm GlazerMalcolm Glazer
Malcolm Irving Glazer is an American businessman and sports team owner. He is the president and chief executive officer of First Allied Corporation, a holding company for his varied business interests, most notably in the food processing industry...
in 2005. Glazer used PIK loans, which were sold to hedge funds, to fund the takeover, much to the displeasure of many of the club’s supporters, because the burden of the debt was placed on the club itself, not the Glazers.
See also
- Negative amortizationNegative amortizationIn finance, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases...
, a similar arrangement in mortgage loanMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s - Payment in kindPayment in kindPayment in kind refers to payment for goods or services with a medium other than legal tender ....
- Zero-coupon bond