Payment in Kind (PIK):Mechanics and Rise in Prominence

This piece was originally produced for and published in the Palgrave Encyclopedia of Private Equity.

Defining Payment in Kind (PIK) and its mechanics

Payment in Kind (“PIK”) refers to the payment of liabilities in the form of additional securities.

In return for capital from lenders, borrowers repay creditors in the form of principal (the amount borrowed) and interest (the cost of borrowing). While principal payments are typically either spread over time (amortization) or are due in full as a lump sum when a credit facility matures (bullet payment), interest expenses most often are paid in cash and on a regular basis.

However, interest can be “PIKed.”

PIK is akin to issuing new securities, most commonly debt, equal to the interest payment due rather than paying for interest expense in the form of cash. After PIK interest is “paid” (capitalized), subsequent interest payments are made based on the original principal as well as on newly capitalized principal issued from prior PIK interest payments (Altman, 2019). PIK interest compounds.

For example, suppose a loan with $100 million principal remaining and quarterly interest of $2 million has a feature that allows the borrower to make the next interest payment in kind (PIK). In lieu of a cash interest payment at the end of the quarter, the loan principal would rise to $102 million. Subsequent interest payments would then be based on the higher $102 million principal amount.

PIK inherently has heightened sensitivity to credit risk of the borrower, relative to cash interest, since the duration of the underlying loan is effectively extended by capitalizing interest for later payment (Bodenheim, 2017). PIK also subjects lenders to the possibility that a borrower won’t be able to replace the delayed interest expense with new debt (refinancing risk) (Wheeler, 2018). Since many borrowers may plan to finance ballooning interest capitalization through later transactions, refinancing risk can be a meaningful component of underwriting PIK.

Creditors take these risks and others into account when deciding whether to invest in PIK securities.

Types of PIK securities

PIK often comes in two flavors: “true” PIK notes and PIK toggles, the latter being more popular at the time of publication.

PIK notes are loans for which all interest payments come in the form of additional securities added to a firm’s debt burden. All interest is 100% PIK, and the interest payment structure is established at inception (Brittenham and Selinger, 2014). Holders of PIK notes do not owe cash to the creditors of those notes until an agreed upon time such as when the indenture matures, the borrower defaults on the notes, or a party terminates the debt agreement for another reason (e.g., debt becomes payable upon change of control) (Altman, 2019).

PIK toggles, on the other hand, give borrowers the option to either pay their interest expense in cash or in “kind” (Demiroglu 2010).

In some cases, borrowers paying on PIK toggles may have the option to pay a portion of their interest expense in kind, while other debt agreements stipulate that toggles are all-or-nothing: a payment is either all cash or all in-kind. Debt contracts with these repayment options are often described as “partial PIK securities” and “PIKable securities,” respectively (Moody’s, 2021).

Toggle options sometimes exist for only a portion of the life of a loan (Proskauer, 2023). For example, a 5-year loan could have a toggle option that can only be used in the first two years; after those two years pass, all interest on that loan might be due in cash.

As described above, PIK can have additional risks relative to cash-pay. Further, toggle optionality can introduce adverse selection risk to lenders since borrowers may be more inclined to elect the PIK option when they are in poor financial condition (Dalkır, 2019). Creditors often require additional compensation for these risks in the form of higher interest rates for PIK interest versus cash interest in PIK toggles (Schwimmer, 2015). For example, cash interest on a PIK toggle may be payable at some floating base interest rate like the Secured Overnight Financing Rate (SOFR) plus an additional interest rate (the “spread”); while the PIK rate might be an additional spread of 50 to 300 basis points above the cash interest rate (Schwimmer, 2015; Proskauer, 2023). Alternatively, borrowers may pay a fixed premium for every unit of interest they capitalize instead of paying in cash, for example PIK’ing an additional 25 basis points for every 100 basis points of notional interest that would otherwise be due in cash (Proskauer, 2023).

Other PIK mechanics and variations

Contingent cash-pay requirements (“pay if you can”) have been included in many recent PIK transactions. A borrower of a PIK instrument that has contingent cash pay requirements must make payments in cash when certain financial thresholds are met (Fitch, 2022). This “pay if you can” structure differs from the previously more common “pay if you like” arrangement because guardrails are in place to protect creditors from losing access to cash interest when it could be available (Brittenham and Selinger, 2014).

Minimum cash and maximum PIK provisions in loan documents can define how much toggle may be used by a borrower (Proskauer, 2023). To manage how much interest is deferred and how much cash income a debt instrument with a PIK toggle produces, creditors may introduce minimum cash interest conditions and/or limit how much interest may be paid in kind. These are particularly useful in placing guardrails on partial PIK securities, which allow debtors to choose how much of their interest expense they want to pay in cash and in kind.

Most often, these provisions apply to spreads above a base rate (e.g., SOFR) or the entirety of the interest rate if it is given in absolute terms. For example, for a SOFR+700 basis point interest rate, minimum cash provisions and maximum PIK provisions would typically be stipulated in reference to the 700-basis point spread.

For contracts in which spreads above a base rate or absolute interest rates change over time, these two provisions may cover different scenarios. If an interest rate increases from 12% to 20% over the course of a number of years, a combination of minimum cash and maximum cash provisions could change a borrower’s option set over the course of the life of a loan. In this example, a 2% minimum cash provision would suggest that in year 1 the borrower can PIK 10% (12% minus 2%) and in the final year of the loan the borrower can PIK 18% (20% minus 2%). Adding a maximum PIK provision of 15% would place an upper bound on how much interested can be PIKed in the later years of this example.

Cash and PIK components of mezzanine debt: many PIK securities allow for a combination of payback ‘currencies’ (i.e., both in-cash and in-kind repayment). Unlike toggles, in which there is an option to elect between cash and PIK options, cash plus PIK securities are typical of many “mezzanine” debt packages, so named for their positioning in the middle of the capital structure, between more senior debt and equity (DeMarzo, 2021). In the case of some mezzanine loans, obligations contractually pay a portion of their interest in the form of PIK capitalized principal (Moody’s).

Cash plus PIK mezzanine securities by default have both cash and PIK interest payments. For example, a 10%/3% cash plus PIK mezzanine note would have an interest rate of 10% in cash plus a 3% PIK component that compounds.

A cash plus PIK mezzanine note could include a PIK toggle. For example, a note might have a 13% interest rate in the form of 10% cash plus 3% PIK, but with an option to toggle to a 14% interest rate for reduced cash interest, such as 6% cash and 8% PIK (in this example, the toggle would increase the overall interest rate by 1%, from 13% to 14%).

Holdco PIK notes are PIK notes issued at the holding company-level under which an operating company or companies sit (Federman, 2020). These are typically written as traditional PIK notes with 100% of interest paid in kind. While contractually, Holdco PIK notes may be written as senior notes, structurally, these notes are subordinated to liabilities held at the operating company-level (Kitchen, 2019). Holding company value is derived from the equity value of its subsidiaries; if debt is held at a subsidiary and that subsidiary defaults on its loan, subsidiary-level debt has priority over any liabilities, including Holdco PIK notes, held at a parent affiliate (ibid.). That is to say, “senior” Holdco PIK notes are effectively a form of junior capital (and for this reason, often are priced at high rates of interest relative to many other forms of debt securities).

PIK Trends

Popularity of PIK in subordinated instruments

While in theory, any debt security could provide PIK as a form of interest payment, in practice, PIK is usually found in subordinated and mezzanine debt. In the event of default, instruments with PIK provisions often receive payback priority below that of more senior debt such as senior term loans and senior secured notes. The combination of a junior position in the capital structure and the equity-sharing characteristics of deferred payments that compound make PIK instruments higher yielding than many other fixed income securities (Kitchen, 2019; Proskauer, 2023). In fact, these instruments can provide creditors with equity-like returns in a vehicle that provides downside protection.

Payment-in-kind prevalence has been volatile over the past two decades

PIK instruments, especially PIK toggles, have grown in popularity over the past two decades. Their issuance and the election of PIK options in toggles coincide with times of increased uncertainty and reduced liquidity (Goldwater, 2021).

Only five LBO firms issued PIK toggle debt during the 8 years from 1997 to 2004. During the 32 months after 2004, twice as many LBO firms issued such instruments. In 2007, 20% of buyout firms took out PIK toggle debt (Demiroglu and James, 2010). At that time, 13% of junk-rated corporate bond sales in the US included PIK toggles (Platt, 2017).

PIK prevalence spiked during the great financial crisis (with $27.7 billion of PIK toggle face value outstanding in 2009) (Platt, 2017). Volumes of the issuance of debt instruments with PIK language represented 11% ($16 billion) and 27% ($14 billion) of total U.S. high-yield issuance in 2007 and 2008, respectively (Fitch, 2022). At that time, many companies with outstanding PIK toggle notes defensively elected to pay interest in-kind to preserve their liquidity in uncertain times (Brittenham and Selinger, 2014).

PIK issuance declined in the following years (Platt, 2017) and picked back up during the global pandemic (Butler, 2020), as did the election of PIK options in debt contracts.

PIK income reached 12% of total loan income in the quarter ending in September 2020 for middle market private direct lenders in the US (Cliffwater, 2023)[1]. That proportion of income has since declined to fluctuate between 7% to 8% between 2021 and the first quarter of 2023. PIK interest was typically 3% to 6% of income from directly originated corporate lending between 2011 and 2019 (see Exhibit 1). PIK as a percent of overall income is a function of the prevalence of PIK and PIK options in debt contracts, the interest rate of PIK securities relative to income from other securities in a portfolio, and the degree to which borrowers elect to use the PIK option.

Exhibit 1: Portion of Cliffwater Direct Lending Index (CDLI) BDC loan income in the form of PIK, 2004 to Q1’23

The Cliffwater Direct Lending Index (CDLI) is an asset-weighted index of approximately 13,000 directly originated middle market loans totaling $276 billion as of March 31, 2023. It tracks the underlying assets of exchange-traded and non-traded Business Development Companies (“BDCs”).

Source: Cliffwater.

The high interest rate environment in 2023 has increased borrower appetite in PIK instruments.

When cash is expensive, many borrowers are interested in using PIK to reduce the cash burden of financing their growth.

Advantages of PIK toggles

PIKs are often useful in the early stages of leveraged buyouts (“LBOs”) when the likelihood of low liquidity is high. At that stage, many firms have high debt loads and/or are amid a business transition (Goldwater, 2021). Portfolio companies of private equity firms can use PIK toggles to decide whether to pay interest in cash. If a firm cannot produce sufficient cashflow to support their interest coverage, PIKs provide flexibility to delay payment until more cash is available or until an exit/sale of the asset.

Instruments with PIK options create an opportunity to conserve cash and effectively take on additional debt in the future at a predefined interest rate.

Debt often constricts the optionality of firms. Covenants in debt contracts may prevent firms from borrowing additional capital. And an inherent feature of most debt contracts is that they create consistent drains on liquidity through regular interest and/or principal payments.

If a firm is undergoing distress, borrowing can become even more challenging. The cost of borrowing for firms often goes up in times of distress (Damodaran, 2002). When a firm is short on cash, the risk of borrower default may be greater for creditors, and therefore creditors often require higher interest rates on debt to compensate for that added risk. Further, access to lenders can be a challenge when a borrower is less creditworthy (ibid.). And even if lenders want to provide a distressed firm with capital, debt covenants on existing liabilities can make raising additional debt hard or impossible during times of financial distress (Goldwater, 2021).

However, PIK interest obligations may be delayed at a pre-negotiated price that was set when a firm was likely in good financial health. Some of that adverse selection risk is typically already priced into the PIK product – recall that often PIK interest is charged at a higher interest rate than cash interest.

PIK toggles align creditors with borrower value

The pricing of PIK toggles can be more efficient than that of “true” PIK notes as shown by Dalkır (2019). Lenders are more closely aligned to true firm performance when lending with PIK toggles versus when lending on pure PIK notes. In cases where a borrower is healthy, borrowers are more likely to pay interest in cash (either by choice or by contractual obligation), and lenders are paid at a lower interest rate than were the PIK option used. When a borrower is undergoing stress, subordinated lenders effectively take a larger stake in their borrower in the form of additional principle at a higher rate of interest. In the event of a borrower’s default, PIK holders may stand to see higher recovery (either through reinstated debt or by equitizing their principal for a larger portion of the firm) than similarly situated, pari passu[1], subordinated lenders that did not see a principal increase if these securities are not impaired, requiring a haircut to their face value.

If done correctly, and as long as the debt balance remains below the enterprise value of a borrower, the value of PIK toggle indentures can be more consistent than PIK notes for firms with diverging performance (Dalkır, 2019).

Cash benefits of PIK

There can also a real cash benefit to PIK interest that comes from a tax shield on a deferred interest expense. Compounded interest payments like PIK are tax deductible in most jurisdictions (Garay, 2016). This means that firms that elect PIK may realize a tax-deductible expense from their higher yielding PIK interest. That expense reduces a firm’s overall tax burden without requiring the firm to layout the cash for that interest expense until later.

Challenges associated with PIK

In addition to the benefits that PIK may offer borrowers and creditors, there are many risks and challenges related to PIK securities.

As discussed previously, the prevalence of PIK spiked during the last two periods of broad economic distress: the great financial crisis and the onset of the global pandemic (Platt, 2017; Cliffwater, 2022). Not only did issuance of PIK instruments rise around these periods of time, but borrowers were more likely to elect to use the PIK options in toggles when there was increased uncertainty and reduced liquidity. The behavior of increasing the use of this form of payment when businesses are most challenged may suggest greater risk associated with PIK relative to other types of securities (Goldwater, 2021). In fact, in their rating methodology for collateralized loan obligations (CLOs), which may hold PIKable securities, Moody’s notes that PIK in a portfolio of loans gives rise to liquidity concerns (Moody’s, 2021). Further, they explain that for higher rated CLO tranches (more on this below), if loans pay in kind for a certain length of time, those loans may be considered to have defaulted.

PIK exposes creditors to risks above and beyond the risks associated with other junior capital. In addition to perhaps signaling greater credit risk due to firms being more likely to elect PIK when they are less likely to be able to service debt (adverse selection) (Dalkır, 2019), creditors must underwrite other risks. For example, since PIK pushes out the timing of cashflows for when creditors will be repaid, PIK instruments have heightened duration risk (Bodenheim, 2017). Fixed interest rate PIK instruments (common in mezzanine securities) may be particularly sensitive to changes in risk-free interest rates. Further, relative to other forms of debt, PIK may pose greater refinancing risk. This is the risk that borrowers will not be able pay back liabilities by raising debt in the future. This heightened risk in PIK instruments exists because more of the value of a PIK loan may be tied to a future refinancing than a loan that has its interest paid throughout the course of the loan in cash (Wheeler, 2018).

Similarly, in the event of default, holders of PIK securities may be worse off than their non-PIK peer creditors. If debt that is pari passu to PIK is impaired, PIK investors may be more negatively impacted than those similarly situated non-PIK investors with all-cash interest positions, as discussed above. Creditors holding PIK securities effectively take on a larger portion of enterprise value (EV) when interest is PIK’d. However, if EV falls to the extent that the value of PIK instruments and similarly situated debt are impaired, instruments that accrued PIK interest will see higher face value discounts in absolute terms relative to instruments that did not have face value increases via PIK, all else being equal.

PIK also brings risks of value destruction to borrowers. Often, the real cost of PIK is higher than cash interest; it is not uncommon for a borrower to pay a 50 to 300 basis point premium for interest that they repay in-kind rather than in cash (Schwimmer, 2015; Proskauer, 2023). That cost is borne by the borrower and may ultimately impair the value of equity since PIK interest will come due at some point and the PIK mechanism can give creditors claims on a greater share of an enterprise.

The use and role of payment in kind in collateralized loan obligations (CLOs)

In addition to its use in corporate debt instruments, PIK plays a role in structured finance. Collateralized Loan Obligations (CLOs) serve as a crucial structured finance instrument, offering investors exposure to diverse risk-return profiles from underlying portfolios of leveraged loans.

CLOs aggregate leveraged loans and issue tranches of CLO bonds, which are sold to investors. These bonds entitle investors to receive portions of cash flows generated from the loan portfolio (Lu, 2021).

A CLO has its own capital structure, comprising obligations to various tranches of claims. Senior tranches such as the AAA tranche receive priority in cash flow distributions from the CLO and are compensated with the lowest coupon relative to other tranches. More junior tranches and CLO equity carry higher risk since they are more exposed to losses in the CLO but also have the potential for higher returns (Guggenheim, 2022).

While CLO mandates often do not allow CLOs to purchase assets that are paying in kind at the time of purchase, CLOs themselves may pay CLO investors in kind in certain circumstances (Moody’s, 2021).

As part of the mechanics of a CLO, formulaic tests are run to determine certain portfolio management and distribution outcomes (Moody’s, 2021). When an overcollateralization ratio (OC) test for a CLO tranche is breached, coupon payments to more junior tranches may be withheld so that funds can be redirected to pay down senior obligations (Lu, 2021). Doing so allows CLOs to self-cure after test breaches. This mechanism prioritizes curing breaches at senior levels at the expense of junior and equity tranches.

When payments get cut off for a tranche, they accrue PIK interest (Sallerson, 2020). Missed coupon amounts owed to a tranche can sometimes be added back to the balance of a tranche via PIK (Lu, 2021). This ensures that junior investors remain whole relative to their bond coupon, especially in cases of insufficient cash flow in the CLO.

Should the CLO generate excess cash flow beyond meeting senior and junior tranches' in-period obligations, opportunities may arise to pay down PIK notes, potentially retiring them and providing additional cash compensation to investors. However, it is possible that the PIK balance in a CLO tranche will never be funded. In this event, these CLO bond holders will be impaired.

A parting note

Payment-in-kind (PIK) can provide borrowers with valuable optionality and compensate lenders with equity-like returns. Many features exist that permit borrowers and lenders to tailor the mechanics of PIK securities to meet their needs. PIK securities may be a source of patient capital that provides creditors with access to higher yields and creates much needed flexibility for certain borrowers. However, PIKs can create the opportunity for prolonged financial distress. If a business model is not feasible, having an out to delay paying interest expenses can postpone an inevitable default while a firm burns through precious resources. Lenders balance market, financial, and business considerations to determine how much they want to be paid, how long they are willing to wait, and with how much risk, when they underwrite PIK instruments.

References

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[1] Pari passu, Latin for “equal footing,” refers to two or more parties to a financial contract or claim being treated equally. Two lenders or two debt instruments that have equal priority to one another in being repaid in a financial restructuring are said to be pari passu to one another. Repayment is owed to pari passu parties pro-rata to the size of each party’s claim. If a PIK lender is pari passu to a cash lender, theoretically, the PIK lender will be compensated with additional claims on the enterprise relative to the cash lender since the PIK lender’s principal grows.