Why ‘payment-in-kind’ debt is so appealing — and risky

WHEN private equity firms buy up target companies, they rely on one major source of financial firepower – debt, and lots of it. But what happens when the interest on that debt jumps? For some, the answer is simple: pay it later. 

In today’s “higher-for-longer” rate environment, so-called payment-in-kind debt, otherwise known as Pik, is an appealing but risky way for buyout firms to keep their spending to a minimum while they try to extract returns from the businesses they have acquired. 

It allows them to push back interest payments until the moment when the debt itself has to be repaid. Pik was first popularised by bankers in the 1980s, and made a name for itself when it was used for one of the world’s most famous leveraged buyouts – KKR & Co’s takeover of RJR Nabisco in 1988. 

Pik debt is still relatively rare. For one thing, collateralised loan obligations – the financial products used most often by investors to bundle their leveraged loans – are typically limited in how much Pik debt they can hold. 

But with central banks delaying a shift to lower borrowing costs, Pik is becoming more popular by the day. 

What is payment-in-kind debt?

The interest gets added onto the initial amount of money borrowed when it comes due and is compounded, meaning the underlying debt grows over its lifetime. While Pik can alleviate a short-term cash crunch, it can end up being far more expensive than normal debt. 

There are several flavors of Pik. “Pay-if-you-can” bonds switch from regular interest payments to payment-in-kind when certain conditions laid out in the bond terms are met. There are also “pay-if-you-like” toggle bonds that offer a choice between paying regular interest or switching to Pik. 

At some point, however, the borrower needs to pay up or else negotiate with lenders to push back maturity dates, reset the terms, or refinance – reimburse the debt using money from new investors.  

Pik can only do so much for a company that is already struggling. In April 2023, WeWork swapped around US$1 billion of its bonds for new Pik notes with double-digit percentage yields, and issued new Pik bonds at an eye-watering return of 15 per cent. The move did not stop the company later sliding into Chapter 11 bankruptcy. 

How does Pik work?

Pik is one of the riskiest types of debt, for several reasons. 

It does not come cheap, with some borrowers racking up a Pik interest burden of 21 per cent on an annualised basis. The gamble is that management will use the money saved in the short term to make the acquired business profitable enough to pay off a bigger chunk of debt down the road. 

If the business goes bad, investors not only miss out on cash payments but saddle themselves with a riskier borrower that buckles under the strain of its mounting debts. This threatens the repayment of even the principal. 

Pik debt is typically subordinated and unsecured, which means its providers only get paid after all other lenders have been reimbursed, and they have no claim on any company assets. 

It is also often raised at the parent- or holding-company level of a business, as opposed to the operating company – the part of the organisation that brings in revenue. In this way, a business can increase the amount of debt it has and avoid triggering rules that would otherwise limit leverage. 

Why do companies want to raise payment-in-kind debt now?

Pik is appealing for companies in today’s higher-for-longer interest-rate environment as some are being forced to pay three times more to service their debt when it comes up for refinancing.

Private equity firms have been turning to Pik in order to make their buyouts less expensive upfront. This can give the target company some breathing room so it can focus on growth and invest more money in its operations. 

When markets are at their frothiest, shareholders have been known to pile Pik onto a company to pay themselves a dividend. Such deals were popular in the run-up to the 2008 financial crisis, as well as during the subsequent easy-money era. Packaging company Ardagh Group, owned by Irish billionaire Paul Coulson, is a notable example. 

Who is providing Pik?

Private credit funds are the main driver of the trend. During the decade of rock-bottom interest rates following the global financial crisis, Pik fell out of fashion because debt was so freely available elsewhere – and at a much lower cost. Today, with companies looking for creative ways to deal with higher rates, private credit providers have been offering the option once more. It gives direct lenders an edge over Wall Street banks because Pik is harder to sell in traditional syndicated markets. 

Pik is increasingly popular. Among the ten largest US Business Development Companies – entities that raise capital to lend to small and medium-sized businesses – 17 per cent of loan portfolios contained at least some Pik notes, according to a Bloomberg Intelligence report in February. That is up from 10.5 per cent the previous year. 

One recent example is a US$1.1 billion Pik note provided by Carlyle Group and Goldman Sachs Private Credit to fund administrator Apex Group. 

Private credit providers have also allowed struggling borrowers to tweak the terms of their existing debt and shift to Pik-style interest payment arrangements. In Europe, more than half of all amendments made to private credit-provided debt in the first quarter of 2024 involved a Pik component, according to data from Lincoln International. 

Even banks are willing to offer Pik, with some pitching broadly syndicated refinancings using the debt instruments in order to poach business back from private lenders. These Pik bonds are still rare, with only a handful sold in Europe’s high-yield bond market since Russia’s full-scale invasion of Ukraine in 2022. 

What are the risks?

Pik is risky for almost everyone involved. For shareholders, the most worrying aspect of Pik debt is the way it can snowball to a size that eats into the equity of the business. Lenders of senior debt are probably safest in that they should always be paid back before the lenders of Pik debt and so face the lowest risk of losing money in a bankruptcy. 

But that assumes their lender protections are strong enough to stop the owners and management of the business siphoning off cash or assets out of the structures that the senior lenders have claims to in order to pay off the Pik debt instead. A lot of weak lending documentation signed in 2021 and 2022 allows borrowers more leeway to do this. 

Has Pik gone wrong before?

Yes, plenty of times – most notably:

• EB Holdings II, the holding company for Howard Meyers’ worldwide metals empire, filed for bankruptcy protection in 2019 after a years-long fight with hedge funds over a 600 million pounds (S$1 billion) Pik loan agreement signed in 2007 that allegedly grew over time into a US$2.5 billion liability.

• The US Glazer family piled debt onto Manchester United when they bought the English soccer club in 2005. That included more than 200 million euros (S$378.3 million) worth of Pik notes that ballooned in cost, fueling angry protests by club supporters. If the Pik debt had not eventually been paid down and was held to maturity, it would have ballooned to almost 600 million pounds. BLOOMBERG