What is Payment In Kind (PIK) Loan Interest?

What is Payment In Kind (PIK) Loan Interest?

Payment In Kind, or PIK, is an often misunderstood topic in leveraged finance. In the industry it is used to describe interest that can be paid by a borrower in a deferred manner via the issuance of additional securities instead of the more typical form of cash. This is attractive to companies that want to avoid making current cash outlays for debt interest, such as during a management or leveraged buyout, or during a growth phase of the business.

It is best illustrated by a simple example:

– If $1 million of non-amortizing debt is borrowed at a 10% current cash interest rate the yearly interest payments are simply $100,000 (i.e. $1 million x 10%). The principal balance remains $1 million and the cash payment will be the same each year until maturity.

– If the same $1 million of non-amortizing debt is borrowed at a 10% PIK annual compounding interest rate the interest owed for the first year remains $100,000 (i.e. $1 million x 10%). However, the $100,000 is not paid in cash but is added to the principal balance so the note balance increases to $1.1 million. During the second year the 10% annual rate is applied against the higher principal balance so interest for year 2 is $110,000 (i.e. $1.1 million x 10%). All principal and compounded interest is ultimately paid at maturity of the note.

All else being equal, a PIK note will cause a borrower to pay slightly more interest over the life of a loan due to the compounding nature. However, the critical point is that it lessens the cash portion of debt payments for a borrower allowing that cash to be utilized for other corporate needs such as growth investments, capital expenditures, or acquisitions.

At F.N.B. Capital Partners, we will often structure a loan with a portion of the interest rate paid with current cash payments, and some of the interest rate as deferred PIK interest (at the option of the borrower). For example, to provide some flexibility, a 14% mezzanine loan could entail a 12% current cash interest payment plus 2% deferred PIK interest. In this case, the borrower would pay the 12% current cash interest portion and then has the option to pay in cash or PIK the 2% depending on the cash needs of the business.

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