A PIK loan, also known as a Payment-In-Kind loan, is a loan where the borrower does not pay interest in monetary terms. In a PIK loan, a borrower pays interest in additional debt rather than cash.
With PIK loans, the size of debts can quickly increase and add up to the principal amount of the loan. Similarly, the interest in-kind payments are calculated based on compounding. Therefore, experts consider PIK loans as high-risk loans.
That is where the loan also gets its name from. Since a business pays the interest payment in similar debt or loan, it is known as a payment in kind.
With some types of PIK loans, the interest on the loan is paid back at specific predetermined times. With other types of PIK loans, the interest is added to the overall amount of the loan and capitalized.
Features of PIK Loans
PIK loans are generally unsecured loans. This means a borrower does not have to offer an asset as a security to obtain it. However, due to being unsecured, PIK loans also come with a higher rate of interest.
PIK loan is a type of mezzanine debt that can help businesses manage their cash flows without having to worry about making cash interest payments.
On the date when interest is due, the borrow simply issues more debt to the lender. Similarly, all the debt gets paid back to the lender on the maturity date of the loan.
PIK loans are long-term loans because they can span over 5 years or more. Some types of PIK loans may also come with detachable warrants or other similar options to allow the lender to participate in the future success of a business.
These loans are more favorable to the lender rather than the buyer. However, since the lender does not receive regular interest payments, like other types of loans, the income is considered deferred for them.
PIK loans also set out what kinds of payments will be acceptable as paid in kind. Usually, a borrower will pay interest in similar debt instruments as the loan.
Furthermore, these loans will also specify the mechanics for interest payments. As mentioned above, the interest can either be paid in debt when it is due or it can be capitalized and added to the existing principal amount of the loan.
Advantages of PIK Loans
PIK loans may have some advantages for the business obtaining them. PIK loans are specifically more attractive to businesses suffering cash flow shortages or liquidity problems but are capable of paying the lender in the form of debt.
Therefore, these businesses may find PIK loans more advantageous as they do not require them to make regular interest payments.
Similarly, PIK loans are more advantageous for businesses in their growth phase or those who are going through management or leveraged buyout. It helps the business avoid making cash payments for interests during those times.
It assists the business in protecting its liquid assets. Similarly, businesses that do not have assets to provide as a security for loans may find PIK loans helpful.
Drawbacks of PIK Loans
While PIK loans may have some advantages for a borrower, they are more favorable for the lenders. First of all, PIK loans, as discussed above, are riskier than other types of loans. When a business pays interest with debt, it piles up on more debt making the business overleveraged.
Due to the compound effect on PIK loans, the business will have to pay even more on the interest debt payments. Similarly, while PIK loans are not secured, the interest payments on these loans may be significantly higher than other normal loans.
Similarly, paying debt through debt doesn’t rid the borrower of their responsibility to pay but only defers the payment to a later date.
Therefore, the borrower has to pay much more in the future than it would have to if it paid regular interest payments in cash. Similarly, if the business cannot pay the debt on the maturity date, it can go into liquidation.
Lastly, PIK loans, while favorable for lenders, may also come at a higher risk for them. First of all, the risks for a lender increase due to the loan being unsecured.
Similarly, since the lender gets paid in more loans, this type of loan may not be suitable for lenders who require regular cash flows from their loans. Similarly, due to the value of debt increasing over time, the risks for the lender will also increase.
Conclusion
A Payment In Kind (PIK) loan is a type of loan in which the borrower pays the interest on the loan with further debt. PIK loans are unsecured loans that come with higher interest rates.
Similarly, PIK loans are long-term loans that generally last for over 5 years. PIK loans may have some advantages for some businesses, though, they are generally more favorable towards the lender. However, PIK loans get riskier with time for lenders.
