PIK loan

A PIK (Payment In Kind) loan is a type of loan which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity or refinancing date, not even interest or parts thereof (see mezzanine loan), thus making it an expensive, high-risk financing instrument. PIK is to be interpreted as interest accruing until maturity or refinancing.

PIK loans are typically unsecured (i.e., not backed by a pledge of assets as collateral) and/or with a deeply subordinated security structure (e.g., third lien). Maturities usually exceed five years and in a standard offer, the loan carries a detachable warrant (the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) or a similar mechanism to allow the lender to share in the future success of the business, making it a hybrid security.

PIK lenders, typically special funds, look for a certain minimum internal rate of return, which can come from three major sources: arrangement fee, PIK, and warrants. There are also minor sources, like a ticking fee. The arrangement fee, usually payable up-front, contributes the least return and is more aimed to cover administrative costs. PIK is interest accruing period after period, thus increasing the underlying principal (i.e., compound interest). The achieved selling price of the shares acquired under the warrant is also a part of the total return of the lender. Typically, refinancing of a PIK loan in the first years is either completely restricted or comes at a high premium (i.e. prepayment protection) to suit internal requirements of investing funds.

Interest on PIK loans is substantially higher than debt of higher priority, thus making the compound interest the dominating part of the repayable principal. In addition, PIK loans typically carry substantial refinancing risk, meaning that the cash flow of the borrower in the repayment period will usually not suffice to repay all monies owed if the company does not perform excellently. By that definition, PIK lenders prefer borrowers with strong growth potential. Because of the flexibility of the loan, also in the long term, there are basically no limits to structures and borrowers. Plus, in most jurisdictions the accruing interest is tax deductible, providing the borrower with a substantial tax shield.

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Wikipedia