Payment in Kind Bond

Payment in Kind (PIK) Definition

Where interest is paid off by the issuer of a bond via additional bonds issue instead of cash payment, it is known as payment in kind bond, thus no interest is paid until maturity of the bond and total interest is paid at the time of maturity and hence it lessens the cash payment burden of the issuer of debt or bonds.

Explanation

The Capital structure of a company is nothing short of a chequered board. Various modes of financing are available to suit the situation as well as the requirement of the companies. We all know that a simple debt structure involves procuring finances followed by subsequent payment of interest and principal on pre-determined dates. However, when it comes to corporate financing, this has many more layers added to it. Companies usually plan to design a structure that is easy on the cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, tax-efficient, and flexible enough to factor in unforeseen events.  One such debt structure is called “Payment-in-Kind” or PIK.

PIK bond is the one on which the borrowing company pays no cash interest until the total principal is repaid or redeemed.  Instead of this, on each interest payment due date, the accrued interestAccrued InterestAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period.read more is capitalized. It may either be added to the principal amount or maybe ‘’paid’’ through the issuance of further loan notesLoan NotesA loan note is an instrument issued by the lender to the borrower when granting a loan. It contains payment terms and conditions, interest rate, tenure and all the legal bindings and obligations of both a lender and a borrower.read more, bonds, or preferred stocks with interest or dividends paid in securities. In fact, this is how it derives its name, which means the payment of interest can be made through instruments other than cash. It is to be noted that the securities used to settle the interest or dividends are generally identical to the underlying securities, but on many occasions, they have different terms.

Going back to the basics, payment in kind is nothing but a form of Mezzanine debt. Mezzanine debt is the intermediate layer of capital that features between secured senior debt and equity. This is a capital that is generally not secured by assets and is primarily disbursed depending on a borrower’s (company’s) ability to repay the debt from free cash flowCash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).read more. Mezzanine financing is usually more expensiveMezzanine Financing Is Usually More ExpensiveMezzanine financing is a type of financing that combines the characteristics of debt and equity financing by granting lenders the right to convert their loan into equity in the event of a default (only after other senior debts are paid off).read more than senior debt; however, it is less expensive than equity.

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Example

Let us understand Payment in Kind in a simpler way:  Assume a company takes a mezzanine loan for $20 million with a 15% in current cash interest and 4% in PIK interest, without warrants and with the due date of note in 5 years’ time. After a year’s time, the current interest, $3 million, is paid in cash as per the terms of the deal, while the PIK interest of $800,000 is paid in security and is accumulated to the principal amount of the note, increasing that amount to $20.8 million. This continues to be compounded till the end of the fifth year when the lender will receive the Payment in Kind interest in cash when the note is paid at maturity.

Features of PIK or Payment in Kind

The main features of a PIK or Payment-in-Kind debt are:

UnsecuredThese loans are typically unsecured, i.e., they are not backed by any kind of pledge of assets as collateral
MaturitiesThe maturity of the Payment-in-Kind debt usually exceeds 5 years
Hybrid SecurityThis loan comes with a detachable warrant, which implies having the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time, or any kind of similar mechanism which facilitates the lender to have a share in the prospective success of the business.
Restricted refinancingRefinancing of Payment in Kind loans is usually restricted in the initial years. In case it is allowed, it comes at a high premium

What are the reasons for taking Payment In-Kind?

We know that most companies opt for Payment in Kind due to the certain liberties it provides. Let us dig further to understand the detailed reasons to include Payment-in-Kind (PIK) debt in a leveraged capital structure.

Increased leverage

This debt instrumentDebt InstrumentDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more augments the borrowing capacity of a company, allowing them to leverage their capital structure without creating too much pressure on their cash flow.

Flexibility

Payment in Kind debt gives the borrower a greater deal of flexibility as compared to other debt instruments. This further enables them to protect cash for other capital expendituresCapital ExpendituresCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more, inorganic growth, or acquisitions or to hedge against the possible downturns in the business cycle.

Cash-out events

Many times, PIK is used before a cash-out event (for example, an IPO or liquidation) in order to anticipate and lock-in cash realizations and protect ‘’upside’’ for the equity sponsor at the same time.

Suitable for companies with the long operating cycle

For companies that are usually cash-strapped and have long gestation cycles for their products, Payment in Kind seems to be the most suitable form of financing. They have the opportunity to scale up their operations with additional financing but with minimal cash outflow.

Types of Payment in Kind

Payment in Kind manifests itself in various forms. While the underlying concept remains the same, there are minor variations according to the situation and the financing goal. Some of the popularly used forms are:

Types of Payment in Kind

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For eg:
Source: Payment in Kind Bond (wallstreetmojo.com)

#1 – True PIK

The obligation to pay interest (or a portion of the interest) in kind is compulsory and is predefined in terms of the debt. This is actually the plain vanilla kind of PIK.

#2 – Pay if you can

The borrower (or issuer) is supposed to pay interest in cash if certain restricted payment criteria are met. If the prescribed conditions are not fulfilled due to situations such as senior debt restrictions preventing the borrower (or issuer) from gaining sufficient funds from its operating subsidiaries), then interest is payableInterest Is PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company's balance sheet.read more in kind, usually at a rate higher than payment in cash. Although these PIK structures cannot avoid the prevailing restrictions or payment test, their compulsory cash-pay nature lowers the financial flexibility and liquidity for issuers.

#3 – Holdco PIKs

Certain PIKs have the added risk of being issued at the holding company levelHolding Company LevelA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies.read more, which means that they are “structurally” subordinated and depend solely on the residual stream of cash, if any, from the operating company to service them.

#4 – Pay if you like / PIK toggle

The borrower (or issuer) can exercise its discretion to pay interest for any given period in cash, in-kind, or in a combination of both of them.

PIK toggle notes were quite prevalent in leveraged capital structures before the financial crisis in 2008. When Leveraged Buyout (LBOLBOLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require.read more) was at its peak in 2006, the PIK-toggle structure was the biggest innovation. Usually, the issuer is supposed to inform investors six months in advance before “flipping the switch.” These “PIK toggle” securities empower borrowers to make a choice. They can continue to pay interest on a bond, or they can defer the payment until the bond matures, and in the process, settle for an interest rate that is quite higher than the original rate.

Payment in Kind - Graph
https://www.spglobal.com/marketintelligence/en/pages/toc-primer/hyd-primer#!piks

PIK-toggle note issuance reached about $12 billion in 2013 – the highest level since the credit crisis in 2008 – however it was just 4% of total supply, as compared to 14% in 2008. Most of them backed dividend with a few financing ones. Only one was LBO oriented. Though the U.S. high yield bondYield BondHigh yield bonds are bonds that pay higher interest than others but are assigned lower credit ratings by popular credit rating agencies. Ratings below “BBB” from Standard & Poor and below “Baa” from Moody’s are due to additional credit risks involved in interest and principal repayment.read more market came off from the risk-off period of late 2015/early 2016, that was only to an extent. There has been almost nominal or no PIK/PIK toggle issuance since the second quarter of 2015

PIK Toggle Examples

Neiman Marcus pioneered the trend for PIK Toggle bonds way back in 2005 when it was first bought out by Warburg Pincus and Texas Pacific Group. It is believed that TPG was quite worried as to what would happen if the retailer Neiman Marcus had to weather sudden economic downturn or losses due to wrong corporate policies. It then dawned on them to design an unusual structure where some of the debt it put on Neiman Marcus would be utilized to finance the acquisitionFinance The AcquisitionFinancing an acquisition is the process in which a company planning to buy another company looks for funding through debt, equity, preferred equity or one of the many alternative methods available.read more. If the retailer witnessed unexpected headwinds, it could stop paying cash interest on the $700 million in debt, and instead, pay back a higher sum when the bonds matured in 2015.

Some of the other instances of PIK Toggle were:

It was a deja-vu moment for Neiman Marcus when its new owners, Ares Management and Canadian Pension Plan Investment Fund, in October 2013, issued a US$600 million PIK toggle to partly-finance their US$6 billion buyouts. 

Payment in Kind

Source: Standard & Poor’s/ WSJ

Experts are divided on the opinion about the effectiveness or practicality of the PIK Toggle debt.

 Advocates say that the high-interest rates attached to PIK toggle notes give borrowers a motivation to continue making interest payments unless any kind of financial pressure comes up.  However, on the other hand, S&P’s Leveraged Commentary & Data Group once opined that PIK toggle bonds have an underlying risk quotient because they have the potential to burden investors with more debt in financially-struggling companies and limited cash from them.

PIK in Leveraged Buyout

In leveraged buy-outs, a PIK loan is used if the purchase price of the target is more than the leverage levels up to which lenders agree to provide a senior loan, a second lien loan, or a mezzanine loan, or if there is the limited cash flow available to make payments of a loan (i. e. due to dividend or any merger-related restrictions). It is not provided to the target itself. Usually, it is the acquisition vehicle, another company, or a special purpose entity (SPESPEA special-purpose entity is created to fulfill particular objectives, including devising measures to appropriate financial and legal risk profiles. It has a predefined purpose and a limited scope in terms of activity and is sometimes used as a short term solution to a current or potential problem.read more) that receives the loan.

As a practice, PIK loans in leveraged buy-outs carry a considerably higher interest and fee burden than the senior loans, second lien loans, or mezzanine loans of the same transaction. With yields higher than 20% per annum, the acquirer has to do a prudent assessment that the cost of taking a PIK loan should not exceed his internal rate of return of equity investment.

In July 2004, the leveraged buyout firm KKR refinancedRefinancedRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more its acquisition of Sealy Mattress Company with subordinated pay-in-kind (PIK) notes worth $75.0 million principal amount.

How is Payment in Kind beneficial to lenders or financiers?

Lenders structure their loans with a PIK interestPIK InterestPIK Interest, also known as a Payment in Kind, is an option to pay interest on preferred securities or debt instruments in kind instead of cash. PIK interest is also referred to as dividend payments to investors of securities or equity in kind instead of cash.read more component when they want to enhance the certainty of their investment return. For instance, when the lenders differ with equity research or portfolio management companies on the future value of equity, they may prefer receiving cash interest and Payment in Kind interest instead of cash interest and warrants to purchase equity. The value of a warrant, upon exit, becomes uncertain. Thus the contractually certain, compounded PIK return appears more appealing.

For a mezzanine or private equity investor, PIK is most often the most suitable strategy whenever one wants to “lock-in” an investment return. In fact, these lenders prefer the PIK feature because not only do they receive new security in the portfolio company without deploying any additional cash, but it results in a compounded interest effect, which in turn increases the overall investment return.

PIKs rank high on underlying risk

The position of PIK debt is usually after other debt in a financing structure, which has a cash pay interest option.  Servicing the debt with interest in kind rather than in cash comes at a premium – PIK interest is naturally higher than cash interest.  This is done to compensate lenders (or investors) for relinquishing their option to receive their cash-pay interest throughout the tenure of the debt. In fact, the lenders have to take on additional credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more by increasing the amount of principal they are due to receive as the interest keeps accumulating. However, the interest is compounded annually, gives a compound return.

Conclusion

Despite all this, PIKs still have consistent demand, though lower than what it was prior to the credit crisis in 2008. One of the major reasons why lenders still willing to invest in PIK debt despite it being branded as a  high-risk debt is because the issuances did post-crisis have seen judicious and restraint in the usage of this debt by companies. It brings us to an important point that while there are many avenues for corporate financing, some of which, like PIK debts come with a unique mix of flexibility and risk, it is ultimately the borrower’s judgment in selecting the debt that counts.  Deferring cash interest payments may sound attractive but will the company be comfortable in the bond issuances, and the increased principal payment is something that calls for astute decision making.

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