10 November 2015

Understanding PIK

Basic features

What is PIK?

PIK stands for "paid in kind" or "payment in kind".

PIK debt is debt on which the borrower (or issuer) pays no cash interest until the principal is repaid (or redeemed).  Instead, on each interest payment date the accrued interest is capitalised and either added to the principal amount or may be ‘’paid’’ by the issue of further loan notes or bonds. Depending on the jurisdiction, the choice made may have an impact on tax treatment.

The term “PIK” is used in various contexts to refer to:

  • interest that is paid in kind rather than in cash
  • debt that includes a PIK feature – as in a PIK facility (a loan under which interest is capitalised) or a PIK bond or note (a debt security under which interest is paid by issuing additional securities of the same type)
  • the additional debt securities themselves that are issued in satisfaction of the interest payment obligation.

Risk

PIK debt usually ranks behind other debt in a financing structure, with that other debt having cash-pay interest.  It is often issued through a holding company and is structurally as well as contractually subordinated.  

Paying interest in kind rather than in cash comes at a price – PIK interest tends to be higher than cash interest.  This is to compensate lenders (or investors) for foregoing cash-pay interest throughout the term of the debt. These lenders instead have to assume additional credit risk by increasing the amount of principal owed to them, although the fact that the interest is compounded annually gives a compound return.

Instruments

PIK debt can be private or publicly issued debt, and can be structured in a variety of ways.

In a US context, PIK represents a variety of high-yield debt, often issued in conjunction with and ranking behind high-yield bonds.

References to “PIK bonds” are generally to traditional US public deals which involve the issuance of a high yield bond along with a PIK bond.  The PIK bond will generally be structurally subordinated to, and key covenants and terms will be aligned with, the high yield bond.

In Europe, PIK debt traditionally features in the private banking market where a PIK facility is put in place to complement a senior facility.  The terms of the PIK facility are modelled on those of the senior facility or simply on a tranche of the senior facility.  Alternatively, if a US-high-yield bond style PIK bond is issued along with a senior facility, the covenants will be different but the PIK bond may include a term which states that any action that does not breach the senior facility will not breach the PIK bond.

Varieties of PIK

Three main variants of PIK have been developed, as follows :

  • True PIK
  • The requirement to pay interest (or a portion of the interest) in kind is mandatory and is set out in the terms of the debt at the outset.

  • Pay if you can
  • The borrower (or issuer) is required to pay interest in cash if certain restricted payment tests are met.  If prescribed conditions are not met (eg financial covenants are below set levels, or senior debt restrictions prevent the borrower (or issuer) from obtaining sufficient funds from its operating subsidiaries), then interest is payable in kind, usually at a higher rate than payment in cash.

  • Pay if you like / PIK toggle
  • The borrower (or issuer) can choose in its discretion to pay interest for any given period in cash, in kind, or in a combination of the two.

    PIK toggle notes were common in leveraged capital structures prior to the financial crisis.

Reasons for use

There are many reasons to include PIK debt in a leveraged capital structure:

  • Increase leverage
  • The use of PIK debt increases the debt capacity of a borrower (or issuer), enabling them to leverage up without having a negative impact on their cash flow.

  • Flexibility
  • PIK debt gives the borrower (or issuer) flexibility, enabling them to conserve cash for CAPEX or aquisitions and to weather downturns in the business cycle.

  • Cash-out events
  • PIK is often used in advance of a cash-out event (for example, an IPO) in order to anticipate and lock-in cash realisations whilst preserving ‘’upside’’ for the equity sponsor.

Tax treatment

Interest that is paid in kind by the issuance of further notes or bonds is treated as paid on a current year basis for UK tax purposes.


Market trends

Volume

PIK debt was popular in the lead up to the financial crisis, and is commonly viewed as a product of pre-crisis froth and an indicator of high appetite for risk.  Pre-crisis PIK bond issuances peaked in 2007 with approximately US$11 billion issued globally.

PIK debt has also made a comeback in the years since the financial crisis, although with somewhat different characteristics.  In 2013, approximately US$18 billion PIK bonds were issued globally.

Purpose

Pre-crisis, PIK debt was issued primarily to fund large acquisitions and buyouts, and in some cases to pay for dividends or stock repurchases.  PIK debt was seen as a sign of over-leverage and as a high risk investment.  While PIK debt enables a company to increase its leverage without having to pay cash interest for a time, the high interest rate and rolling up of interest rapidly compounds the effective interest rate and heightens the risk of a payment default.

Following the financial crisis, PIK debt has typically been issued by a holding company to fund equity investment returns such as a dividend or stock repurchase, sometimes in anticipation of a partial or total exit event.  This enables sponsors to accelerate returns on their equity investment, an attractive feature for PE firms during a period of reduced leveraged buyout activity.

Demand

In the low interest rate environment following the financial crisis, a search for yield by high-yield investors and private investment firms has fuelled demand for products (including PIK debt) that offer some yield above the inflation rate.

One of the reasons investors are willing to invest in PIK debt despite its high risk reputation is that post-crisis issuances have typically  been used with more restraint than previously.
PIK bonds issued following the financial crisis to fund equity investment returns differ from typical PIK bonds issued prior to the crisis in a number of ways:

  • Lower leverage
  • Leverage multiples are lower than in large pre-crisis transactions.

  • Shorter tenor
  • The average tenor is 5 years, compared to the previous average of 8 years.  In some cases this is driven by the maturity profile of the issuer’s existing debt.

  • Call options
  • Non-call periods are often limited to one year, with PIK bonds issued in anticipation of an upcoming IPO or other exit event including special call options or equity-claw provisions.

  • “Pay if you can” structures
  • Investors expect interest to be paid in cash.  Making PIK interest payments is not an option to be used at the discretion of the issuer but something that is instead subject to prescribed requirements.

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