PIK loan

A PIK (Payment In Kind) 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 is to be interpreted as interest accruing until maturity or refinancing.

PIK loans are typically unsecured (i.e., not backed by a pledge of assets as collateral) and/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.

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 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 principal. 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.

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 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 (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 leveraged buy-outs 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 leveraged buy-outs. 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. The PIK toggle largely disappeared in the wake of the credit crunch, though in early 2013 there were signs of a tentative comeback.[1] Toward mid-year PIK toggle loans returned in force as the high yield bond market in the U.S. and - relatively speaking - Europe shifted into high gear.[2]

PIK bonds

In modern finance, 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".

Examples

One high profile use of PIKs involved the controversial takeover of Manchester United Football Club in England by Malcolm Glazer 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,[3] because the burden of the debt was placed on the club itself, not the Glazers.

See also

References

  1. ↑ "Europe’s CFOs Do the PIK Toggle Again". CFO Insight. Retrieved 15 February 2013.
  2. ↑ "PIK Toggle Bonds Gain Traction In Europe's High Yield Mart". Forbes.
  3. ↑ Credit crisis one year on: Risky debt notes could be a losing game
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