PIK loan

True PIKs, also known as "mandatory" PIKs, establish the interest payment structure at the time of issuance. That is to say, there is "no variation from period to period other than as scheduled at the time of issuance". Interest is required to be paid solely in kind or through a combination of cash and in kind interest, and may shift to all cash at a given point in time, but all of this is predetermined and agreed upon at issuance.[2]

PIK toggles, also known as "pay if you want", are slightly less risky than PIKs, as borrowers pay interest in cash and may "toggle" to payment in kind at the discretion of the borrower ("pay if you want").[1] Sometimes, the borrower may also be able to PIK some portion of the interest (usually half) while paying the rest in cash; at times, only some of the interest may be paid in kind and the rest is cash-only. This also benefits borrowers, as they may opt for early payment of interest in cash, thereby minimizing the compounded payout at maturity.[3] The documentation often provides that if the PIK feature is activated, the interest rate is increased by 25, 50, or 75 basis points.[4]

The first company to try a PIK toggle was Neiman Marcus in late 2005.[5]

This is a different type of PIK toggle, also known as "contingent cash pay" or "pay if you can", where borrowers pay interest in cash and only "toggle" to payment in kind under certain conditions; for example, if there is insufficient cash, usually determined by a cash flow trigger.[2]

In leveraged buyouts, PIKs is used if the purchase price of the target exceeds leverage levels up to which lenders are willing to provide a senior loan, a second lien loan, or a mezzanine loan, or if there is no cash flow available to service a loan (e.g., due to dividend or merger restrictions). It is typically provided to the acquisition vehicle, either another company or a special purpose entity (SPE), and not to the target itself.

PIKs in leveraged buyouts typically carry a substantially higher interest and fee burden compared to senior loans, second lien loans, and mezzanine loans of the same transaction. With yield exceeding 20% per annum, the acquirer has to be very diligent in assessing whether the cost of a PIK does not exceed the internal rate of return of equity investment.

Before the credit crunch of 2008, several leveraged buyouts have seen some secured second-lien term bank loans coming with PIK or, more frequently, PIK toggle features, in order to support the firm's ability to cover cash interest during the initial period after the leveraged buyouts. If the acquired company performs well, the PIK toggle feature allows the equity sponsor to avoid giving extraordinary returns to the PIK debt, which might happen if the debt were strictly PIK. The PIK toggle largely disappeared in the wake of the credit crunch, though in early 2013 there were signs of a tentative comeback.[7] Towards mid-2013, PIK toggle loans returned in force as the high-yield bond market in the United States and, to some degree, Europe shifted into high gear.[4]

One high-profile use of PIKs involved the controversial takeover of Manchester United Football Club by Malcolm Glazer in 2005. Glazer used PIK loans, which were sold to hedge funds, to fund the takeover, much to the displeasure of many of the club's supporters,[8] because the burden of the debt was placed on the club itself, not the Glazers.

In January 2018, Irish entrepreneur Paul Coulson used a $350 million PIK bond to pay a dividend to a group of shareholders at the Ardagh Group, for which Coulson is the largest shareholder and chairman. The Financial Times interpreted the use of a high-risk PIK bond to be indicative of "the level of risk that debt investors are willing to tolerate as they seek higher yields in hot credit markets".[1] This was unusual because the PIK was raised by a newly formed holding company, with analysts and investors referring to the novel structure as a "SuperHoldCo PIK note" or "super PIK".[1]