PIK Interest, or “Paid-in-Kind” interest, is a feature of debt that allows interest expense to be accrued for a set number of years, rather than be paid in cash in the current period.
In exchange for the deferred payout of the cash interest expense and the borrower retaining the cash for additional time, the debt principal coming due on the date of maturity increases.
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PIK interest stands for “Paid-in-Kind” and is defined as the amount of interest expense charged by a lender which accrues towards the ending debt balance (principal).
Opting for PIK interest helps the borrower conserve cash, since the interest payments are pushed back to a later date.
Or in the case of preferred equity, the payout of cash dividends could be deferred for a set, agreed-upon duration.
The downside to the accrued interest, however, is that the total debt principal increases each year until maturity. In effect, this increases the interest expense due to growth in the principal amount.
With each passing period, the amount of accrued interest due can accumulate quickly due to the effects of compounding interest, which can significantly heighten default risk.
PIK interest benefits the borrower by providing the optionality to push back cash interest payments on debt.
In turn, lenders are compensated by the periodic interest expense that accrues towards the ending balance (i.e. higher principal) until maturity.
The PIK rate also typically accrues at a rate higher than the cash interest rate in lieu of immediate cash compensation.
Each year after the issuance of a PIK security, the following factors impact the PIK interest expense:
Certain debt instruments are structured with a partial PIK component.
For example, a loan with a 10.0% interest rate and 50.0% PIK component means half of the interest will be paid using cash, while the remaining half is accrued.
To calculate the paid-in-kind interest, the formula consists of the PIK rate being multiplied by the beginning balance of the applicable debt security or preferred equity.
PIK Interest = PIK Interest Rate (%) × Beginning PIK Debt BalanceNote that if there are mandatory repayments (i.e. principal amortization) associated with the debt, the formula must account for the repaid debt.
This would reduce the interest expense due and the end-of-period debt balance.
Whether the interest expense is paid in cash or PIK, the debt principal and accrued interest payments must be paid by maturity at the end of the borrowing term, per the lending agreement.
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In practice, debt securities, namely corporate bonds, often come with a fixed PIK schedule outlined in the lending agreement.
But another form of PIK interest is referred to as a PIK toggle, which is an agreement between the issuer and borrower that provides the borrower with the option to defer an interest payment if needed.
Based on the liquidity needs of the borrower (i.e. cash on hand) or other conditional provisions, this feature lets a borrower reduce its cash outflows.
If a PIK toggle is in place, the decision on whether interest expense is paid-in-cash or PIK becomes more of a discretionary decision made on the specific circumstances regarding the credit health of the borrower.
PIK interest can be especially attractive to borrowers looking to avoid interest payments to conserve cash (i.e., leveraged buyouts).
In addition, companies that have found themselves in poor financial conditions and in need of debt restructuring can seek to renegotiate debt terms to include the option for PIK.
To confirm your understanding of the PIK interest concept, review the following accounting question.
Q. If a company has incurred $10 in PIK interest, how are the three financial statements impacted?
Note that lending agreements occasionally include interest expense to be paid in the form of “paid-in-kind” interest (or PIK interest), rather than cash interest.
In such cases, an interest expense coverage ratios can be adjusted to exclude the effects of any PIK interest.
Interest Coverage Ratio = EBIT ÷ (Interest Expense – PIK Interest)In effect, only the cash portion of interest expense should be included in the calculation, because PIK is not an actual outflow of cash.
All else being equal, PIK interest increases interest coverage ratios since they are not counted as part of the “interest” line, but note that interest is still accruing to the debt principal and is due at maturity.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Suppose we’re tasked with forecasting the interest expense of a hypothetical company that has borrowed subordinated notes with the PIK optionality.
The debt assumptions we’ll use for this modeling exercise are listed below.
Rather than a straight 12.0% cash interest rate, 4.0% will be paid-in-cash with 8.0% charged in the form of PIK – meaning that throughout the borrowing period, the 8.0% PIK interest accrues towards the beginning balance.
In Year 1, the beginning balance of $1m is multiplied by the 8.0% PIK rate to calculate the interest expense, which comes out to be $80k.
Therefore, we can see how the $80k of interest accrued towards the principal for the ending balance calculation for Year 1 for a total of $1.08m.
Here, we can see the direct impact that accrued interest (and the increased balance) has on the amount of interest due each period; or put differently, the compounding effects of PIK interest.
For comparison, we’ll calculate the portion of interest expense paid in cash by multiplying the interest rate (4.0%) by the average subordinated notes balance.
Interest Expense = Interest Rate × Average (Beginning, Ending Debt Balance)And since using the average balance in the interest expense formula introduces a circularity into our model, we’ll add a circuit breaker.
For instance, the Year 1 cash interest expense is equal to the 4.0% cash interest rate multiplied by the average of the beginning and ending Year 1 sub-notes balance ($1m and $1.08m). This comes out to $42k for the cash interest payment in Year 1.
If the cash interest component did not exist and the form of interest was instead PIK, no cash interest would be paid throughout the term of the loan.
Once the debt matures, the borrower must repay the original debt principal and all the accrued interest.
But in our simplified example, the subordinated notes balance at the end of each period is equal to the sum of the PIK beginning balance and PIK interest accrued.
So in closing, the principal of the subordinated notes has reached approximately $1.47m by the end of Year 5 from the initial balance of $1m at the beginning of Year 1.
