PIK loan
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[edit] Basics
A PIK Loan is an extreme case of a 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 (finance) 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 (ie. non-recourse, or 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 (finance) (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.
[edit] Return and Interest
PIK lenders, typically special funds, look for a certain minimum internal rate of return 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 are also 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 (ie. 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 jusrisdictions the accruing interest is tax decductible, providing the borrower with a substantial tax shield.
[edit] Leveraged buy-outs
In leveraged buy-outs, a PIK loan is either used if the purchase price of the target exceeds leverage 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 (eg. 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 senior loans, second lien loans or mezzanine loans of the same transaction. With yield (finance) 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.
