Thin capitalisation: practical guidance: private equity: payment-in-kind (“PIK”) notes
Interest accruing on mezzanine lending may not to be fully paid in cash. Interest will often be split into a “cash margin” and a “PIK (payment-in-kind) margin”, with only the interest at LIBOR + cash margin being cash-paid. The PIK margin is satisfied through the issue of PIK notes consisting of further loan notes. PIK notes are recognised as payments of interest for tax purposes, but are further loans which are also interest bearing.
PIK notes are also known as funding bonds. Their presence means that the company’s debt continues to increase and repayment is not required until the arrangement is refinanced.
Alternatively, interest on mezzanine debt may just be rolled up without the use of PIK notes, in which case the deductibility of accrued interest needs to be considered.
Interest met in this way is treated as paid for the purposes of the taxes acts - see the guidance on funding bonds in CFM17030 onwards.
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 notes.
Use of PIK notes can increase the debt capacity of a borrower because a company can borrow without having to actually pay interest. However, 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|
|Interest @ 16%||16||19||21||25||29|
By year 5 the principal outstanding has nearly doubled.
The important question is not just whether the company could obtain such debt at arm’s length but whether it 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 loan principal but disallow any interest that accrues on interest that is not paid.