Companies can raise capital by selling assets, equity -- common stock, preferred stock and warrants -- and debt. Different types of debt include notes, bonds and commercial paper. Normally, debt pays cash interest, but pay-in-kind, or PIK, securities give issuers the right to pay interest in the form of additional debt. PIK securities often pay high interest rates and give issuers some flexibility in managing their finances.
When a company pays interest in kind, it creates additional debt. Clearly, the usefulness of this practice is limited, because at maturity the issuer has to pony up cash to repay the debt. PIK loans normally have maturity dates of five years or longer. This type of debt helps companies conserve cash, which can be especially important for new companies with uncertain cash flows. Because PIK debt builds additional debt, it must carry a sufficiently high interest rate to overcome fears of default, especially if other assets do not secure the debt. Occasionally, the additional PIK debt may have terms different from those of the original debt. PIK debt issuers often attach stock warrants to the loans to “sweeten the pot.”
One type of PIK debt is a “toggle loan,” in which the issuer may pay interest with a mix of cash and additional securities, either debt or equity. If the issuer toggles the loan by making a payment-in-kind, the loan contract may require a boost to the interest rate on the debt. This has the effect of making PIK toggle loans variable-rate instruments. “Holding company PIK notes” are issued by the holding companies of leveraged -- that is, debt-laden -- issuers. The “holdco” PIK instruments normally trade as junk bonds because they are subordinate to debt issued by the operating units of the holding companies. In other words, if the issuer defaults, lenders can only collect whatever cash remains after more senior debt is liquidated. Holdco PIKs often toggle.
Companies often deploy PIK debt for "mezzanine financing" before going public. It’s also useful for financing business expansions and leveraged buyouts -- acquiring companies for debt. Mezzanine financing is so called because it appears in the mezzanine section of the balance sheet, between liabilities and equity. Lenders can repay mezzanine loans with stock if they can’t make timely cash payments. Because mezzanine loans are risky, lenders expect high interest rates, often in excess of 10 to 15 percent. The issuer benefits by using PIK notes for mezzanine debt to avoid paying these high interest rates with cash.
Issuers frequently embed a call option into PIK debt. This gives the issuer the right to forcibly redeem the debt on or after a specified date for a set price. Issuers can save money by redeeming PIK debt before its maturity date and issuing new debt at a lower interest rate. Issuers normally defer call dates for three to four years after the issue date of PIK debt. Call options reduce the attractiveness of PIK loans because early redemption truncates an investor’s high-interest income. Issuers compensate by increasing the yields on callable debt.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.