PIK Interest Definition
PIK 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. Payment in kind option is attractive to companies who do not wish to pay cash during the initial or growth phase of business.
Types of Payment in Kind
Below are the various forms of Payment in kind according to the situations and financial goals.
- True PIK -The obligation to pay interest in kind is predefined and compulsory in terms of debt.
- Pay if you can – In this type of debt borrower is supposed to pay interest in cash if certain predefined conditions are met, but if the predefined conditions are not fulfilled due to some situations, then the borrower needs to pay interest in kind at a higher rate than payment in cash.
- Holdco PIK – HoldcoHoldcoA 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. PIK debts are usually unsecured obligations with a final maturity date. In case of default by the borrower, lenders do not have many options to recover these loans because of unsecured nature, but lenders can claim equity of the borrowers business but these type of debts comes behind the other priority debt claims like trade creditorsTrade CreditorsThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front., which mean Holdco PIK debt can be paid after payment of senior/priority debts.
- Pay if you like – In this form of PIK debt borrower can make payment of interest by cash or kind or a mix of cash and kind. This type of debt gives a choice to the borrower that they can make payment in cash if they have surplus money, or at the same time, if a borrower wants to use this surplus cash to invest in business operation, then he can opt for payment in kind option. The interest rate will change according to their choice of payment. This option is also known as PIK Toggle.
Calculation of PIK Interest
In this type of loan option, because a company is not paying interest on cash, therefore till maturity, every year, interest is getting added in debt, i.e., In principle, meaning more debt means the principle amount continuously grows until the loan matures.
In the below example M/s Stark Inc has taken a PIK Notes of $ 10000 on 01.01.2013. These notes have a 10% PIK interest rate, and these will mature at the end of 5 years.
In normal debt instrumentsDebt InstrumentsDebt 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. each year, these notes will incur interests of $ 1000, which the company has to pay every year.
However, In PIK debt, instead of being required to repay the interest amount, the interest is added to the debt in kind that will increase the debt amount as a result in below example at the end of the first year, i.e., on 31.12.2013, the loan amount will increase to $ 11000, and this will continue to grow till maturity.
Features of PIK Debt/Interest
- These loans are unsecured in nature; it means no need to give any assets as collateral against these loans.
- The Maturity of the payment in the kind loan is 5 Years or more than that.
- RefinancingRefinancingRefinancing 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. of Payment in kind loans is not possible except for the initial year of the loan.
- These loans give some rights to lenders, which means the lender has a right to take a certain number of shares/securities in place of the loan at the time of maturity of the loan, or lenders can take Assets of the company if the company is not performing well.
Advantages of PIK Interest
- PIK loans are taken if the company has a liquidity problem but has the capability to pay interest. It means it is suitable for companies with a long operating cycleOperating CycleThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company's inventories into cash..
- In this option, there is no need to pay interest or dividends in the form of cash.
- PIK loans are usually for a period of 5 years or more.
- PIK loans are generally unsecured loan; it means there is no need for collateral.
- Such loans come with a warrant that gives the lenders a right to purchase a set number of securities at a fixed price.
- In this option, a company can invest the 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., acquisitions, or any kind of growth.
Disadvantages of PIK Interest
- The interest rate on PIK loans is higher than the interest rate on Non-PIK loans.
- Lenders will not get any cash inflow before maturity.
- Since there is no collateral is required, lenders may face huge losses in case of default of payment.
Despite high-interest rate, payment in kind debt is always in demand because it is a blood for those companies who has a cash crunch and companies which are in the growth phase. It gives an option to the borrower not to pay interest on cash immediately, which means they can utilize this cash amount for their business operation. Deferring cash interest payments looks attractive, but it will increase the company’s principal paymentPrincipal PaymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced. at the end of maturity.
From the lenders’ point of view, PIK is the most suitable strategy when they have some believes that they are giving loans to the company, which will grow in the future because lenders will get equity in place of interest, and they did not require to expend any additional cash. Similarly, if there is a loss to the borrower, then the lender will get assets of the business.
This has been a guide to PIK Interest and its definition. Here we discuss the top 4 types of payment in kind interest along with an example, advantages, and disadvantages. You can learn more about financing from the following articles –