INTM519035 - Thin capitalisation: practical guidance: private equity: payment-in-kind (“PIK”) notes
Interest accruing on junior debt may not to be fully paid in cash. Interest might be split into a “cash margin” and a “PIK (payment-in-kind) margin”, with only the interest at a floating benchmark + cash margin being cash-paid. The PIK margin is satisfied through the issue of PIK notes consisting of further debt.
PIK debt is also known as funding debt. Their presence means that the company’s debt continues to increase and repayment is not required until the arrangement is refinanced.
Interest met in this way is treated as paid for the purposes of the Taxes Acts - see the guidance on funding bonds in CFM37410 onwards.
Alternatively, interest on junior debt may just be rolled up without the use of PIK debt, in which case the deductibility of accrued interest needs to be considered.
It is common for the interest on shareholder debt not to be paid in cash but to be paid in kind through the issue PIK debt.
Arguments that the use of PIK debt can increase the debt capacity of a borrower, on the basis that a company can borrow witout having to actually pay interest, should be considered with scepticism. This is because PIK debt increases the borrower’s credit risk. PIK debt typically has a high interest rate and the rolling up of the interest means that the effective interest rate will increase rapidly, as in the following example:
| - | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Principal (m) | 100 | 106.75 | 113.96 | 121.65 | 129.86 |
| Interest @ 6.75% | 6.75 | 7.21 | 7.69 | 8.21 | 8.77 |
| Cumulative debt | 106.75 | 113.96 | 121.65 | 129.86 | 138.62 |
By year 5 the principal outstanding has risen sharply.
The important question is whether a lender would expose themselves to the heightened credit risk that results from the rolling up of the interest. Further, one may also question whether the borrower would wish to obtain the debt on such terms. Would the company be prepared to pay so much interest in the long run, or might it decide that the debt is too expensive to maintain? Depending on the circumstances it may be appropriate to accept the quantum of debt but seek to disallow the PIK effect, in other words, to allow interest on the original principal but disallow any interest that accrues on interest that is not paid.