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Payment in Kind (PIK) loans

PIK loans are a form of debt where the borrower pays interest as additional debt, rather than cash. Depending on how the PIK debt is structured, on each interest payment date the accrued interest is either added to the principal or is ‘paid’ by the issue of additional loan notes or bonds.

How does PIK debt work?

The key feature of PIK debt is that there is no requirement to pay cash during the lifetime of the loan. Instead the amounts that would otherwise be paid as interest are added to the loan or are paid in a non-cash equivalent.

PIK debt can either be private or public and can be structured in several different ways. PIK debts can include deep discount bonds, loan notes and subordinated loans or the issue of bonds on a public debt market.

Private PIK debt is normally arranged and underwritten by senior banks and then syndicated to institutional investors with high-risk appetites. Public PIK debt is structured as a capital markets bond issue.

What is a PIK payment?

PIK payments may be made with the issue of additional debt or by adding interest payments to the overall debt amount (‘the principal’). PIK payments may be mandatory (a ‘True PIK’) or may be triggered by certain events. These trigger events are known as ‘PIK toggles’.

What is a True PIK?

A True PIK is where the interest payment structure is established at the beginning of the loan. Interest is required to be paid solely by payment-in-kind or through a combination of cash and in kind interest. Under certain deals, the repayments may shift from a combination of cash and in kind interest to all cash.

What is a PIK toggle?

PIK toggles allow the borrower to pick whether to pay interest in cash, by payment-in-kind or a combination of the two for any given period. PIK toggles are sometimes known as ‘pay if you want’ loans. PIK toggles allow a borrower to elect a type of interest payment that is most suitable for their financial situation.

During the term of the loan, a borrower can alternate back and forth between the two forms of interest payments. This allows a borrower to reduce its outgoing cash payments by adding unpaid interest to the outstanding balance of the loan. However, PIK toggle interest may become mandatorily payable in cash during the final few years of the loan. The PIK interest payment option is commonly at a higher interest rate than cash interest payments.

PIK toggle notes for acquisition financing are typically issued by the same entity that incurred the senior secured facilities.

PIK toggle loans are riskier for lenders because they assume additional credit risk for the deferred payments. It is common to include a provision in loan agreements to increase the interest rate payable if a PIK toggle is activated.

What is a contingent PIK toggle?

Under a contingent PIK toggle, a borrower is required to pay interest in cash, unless certain circumstances toggle a payment in kind. These sorts of loans are sometimes known as ‘pay if you can’ loans. For example, a loan may provide that a borrower may make a payment-in-kind if financing restrictions prevent the issuer from obtaining the necessary funds from its subsidiaries to meet cash interest payments.

What are the advantages of a PIK?

PIK loans allow a company to borrow without having the burden of a cash repayment of interest until the loan ends. PIK loans are most commonly used in leveraged buyout (LBO) transactions. For more information on LBOs please see Leveraged Acquisition Finance.

PIK loans are particularly helpful 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 interest, such as during an LBO or a growth phase of the business.

PIK debt can allow a borrower to increase its leverage without having a negative impact on its cash flow. PIK gives a borrower the flexibility to preserve cash for capital expenditures and to weather poor trading conditions.

When are PIK notes used?

PIK notes are commonly used in private equity buyouts for shareholder debt. When a private equity provider invests in a company it is common for the private equity provider to subscribe a small portion of its money in ordinary shares in the target company and a larger portion in loan notes. These loan notes are frequently PIK notes that pay annual interest, which can be satisfied by issuing further loan notes.

The issue of PIK notes counts as the payment of interest, which can be deducted from a company’s profits but without impacting its cash position. In this way, PIK notes allow private equity investors to regulate cash outflows on debt without jeopardizing future income if trading declines. 

What are the key features of a PIK facility?

The main feature of a PIK facility is that there is no current cash interest payment. Other key terms of a PIK facility include the conditions under which PIK payments may be triggered, the rate at which PIK payments must be made and any restrictions on when interest payments may be PIK.

The PIK facility will also set out what will constitute a payment-in-kind and the mechanics for payment i.e. whether the interest is added to the principal or whether additional debt is to be issued.

In Europe, PIK debts historically feature in the private banking market where PIK facilities complement a senior facility. The terms of the PIK facility will therefore largely be based on the senior facility or may more simply be a tranche of the senior facility.

What are the risks of PIK debt?

PIK debt typically ranks behind other debt and is frequently structurally or contractually subordinated. For more information on subordination, please see our article on Senior Debt. PIK debt also requires lenders to assume additional credit risk from a borrower because the amount of the principal owed will grow over time. Finally, PIK debt is only viable for lenders who do not require frequent cash payments of interest and can wait until a loan has matured before making a profit.

Does PIK interest go on the income statement?

Interest that is paid in kind by the issuance of further bonds is treated as paid on a current year basis for UK tax purposes. Interest met in this way is treated as paid for the purposes of the taxes act.

Where a borrower makes payment of interest by issuing loan notes, the notes are referred to for tax purposes as ‘funding bonds’. Funding bonds are treated, for tax purposes, as a payment of interest equivalent to the market value of the funding bond at the date of issue, and the withholding tax rules apply. Where there is a UK withholding tax obligation, the issuer is required to issue 20% of the funding bonds to HMRC or pay the tax in cash instead.

A valuation of the bonds is needed to determine the amount of interest paid by the funding bond issue and the amount of income tax to be deducted from that interest. Where unquoted shares or securities are involved the advice of Shares & Assets Valuation should be sought.

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