Payment In Kind: risk or reward?

Partners Ian Corfield, Tom Cox, Andrew Robinson and Ed Horn‑Smith explore the growing appeal of PIK financing.

Over recent years, Payment In Kind (PIK) instruments have become an increasingly popular tool for lenders and borrowers alike, granting greater access to capital and flexibility in loan servicing methods – and with a buoyant UK credit market, it’s likely that we’ll only see it deployed more often.

Despite its popularity PIK has attracted criticism, with some lenders unwilling to allow businesses to effectively bet against their own growth.

Our view is that it can undoubtedly be a force for good – but like most tools, it’s about how you use it.

What is PIK?

Simply put, PIK is an arrangement that allows a borrower to defer interest payments and add them to the principal balance of a loan, which continues to attract interest. When the loan matures, the entire principal, including the accrued (but unpaid) interest, must be settled. 

There are different ways of structuring PIK loans. The two parties can either agree a full PIK, where all the interest is added to the principal amount until the loan matures, or a partial PIK, where some of the interest is paid in cash and some is added to the principal.

Another common option is a PIK toggle, where the borrower has the option to switch between the two at any given time, depending on their current cash flow situation. This was a particularly popular tool employed by lenders during the COVID-19 pandemic, offering borrowers headroom to support liquidity ahead of a return to ‘normal’ trading.

Growing popularity

The tool brings several advantages. For a borrower, PIK can help boost cashflow during the term of the loan. They can use this saving to invest in growing their business or funding capital expenditure, so they are in a better position to support a larger debt load in the future given accelerated profit growth or crystallisation of asset value.

For example, a property developer delivering a new housing project may not have the capital reserves to afford monthly interest payments. PIK would allow them to channel this money into construction, with the aim of creating the value they need to ultimately repay the loan in full.

For lenders, PIK is attractive because it allows them to achieve a higher yield on their initial loan. This is because PIK interest rates attract a premium versus the standard loan interest rates, reflecting the higher risk to the lender, as the risk of default increases as the total debt grows. They also benefit from the compounding effect as interest is added on to the principal, and cash yields rise in parallel.

To this end, the successful use of PIK can be seen as a win-win situation for both the borrower and the lender, and is one example or feature of ‘hybrid funding’ as it blends the pricing features of both debt and equity. Indeed we have seen an increasingly incidence of borrowers seeking means to reduce their cashflow burden through a refinancing of older deals structured when cash pay margin were significantly higher (and base rates virtually zero). The ability to refinance into a lower cash yield structure, with contractual PIK can be very attractive where business can redeploy the cashflow for higher return, value accretive projects.

PIK in Real Estate Finance

Real estate loans can be broadly categorised into three products, namely bridging, development and investment loans. Bridging and development loans have long adopted PIK (or retained interest) as a necessary requirement of loan structures as the asset being funded lacks the necessary income to service interest throughout the loan term.

Investment or ‘term’ loans are typically structured and sized according to the lender’s assessment of the property’s income and its ability to service the loan’s interest burden. Having said this, there are often situations where the asset’s income might not be fully stabilised at the outset as some form of transition is required to be completed before the property maximises its income potential.

Using the office asset class as an example, these transitional situations would include lease-up strategies, say for example as individual floors lease up in an office building. Equally, a rolling capex programme across floors would mean the office has partial income whilst those particular floors are being refurbished. An assessment of the entire building’s income in the short to medium term would be required to see what percentage of the interest burden can be serviced from the partial income, thereby resulting an element of PIK interest until the building is fully refurbished and producing maximum income. These transitional business plans can of course apply to other asset classes within real estate, e.g. hotels, industrial etc.

In terms of funding appetite, within the wide spectrum of investment lenders, there exist alternative lenders, namely debt funds tend to be the ones who can offer greatest flexibility to accommodate these business plans. Margin ratchets are also available as the property fully stabilises its income. 

PIK as an agent of doom?

PIK is not inherently ‘good’ or ‘bad’— its effectiveness depends on the context, whether providing flexible capital for growth or as one vital tool to support turnaround efforts. 

On one hand, introducing PIK financing during a turnaround can preserve cash, which is obviously a rare commodity in times of stress and distress, and therefore helps provide time to stabilise operations and positioning for growth leading to a stronger recovery for creditors and shareholders.

However, the source of distress in the first place could equally be a result of historic covenant-lite financing instruments and PIK interest build-ups.

PIK is just another way of attracting the right kind of capital for your business plan, providing the capital the borrower needs to grow their business, while also providing visibility and strong returns to the lender.

Ian Corfield Partner Restructuring Advisory

Changing perceptions

At the time of writing, the UK credit market is highly active, with a continuing imbalance between supply and demand. A slowdown in activity post-pandemic means that many lenders are sitting on high capital reserves and are ready to deploy. Meanwhile, ongoing headwinds – from inflation to supply chain uncertainty – means that more businesses than ever are looking for cash injections through credit – lenders must pick their battles accordingly.

For this reason, we’re seeing more lenders offer PIK to make capital stacks more flexible for borrowers and support their growth ambitions. However, this has caused concern amongst some. This is because PIK became more popular during the pandemic when many firms were struggling to pay the interest due on their loans, leading to an enduring suspicion that it can be used to mask underlying performance or be a trojan horse for loan-to-own strategies.

Yet while there was a time when this may have been more prevalent, that’s not necessarily a fair assessment today. In reality, PIK is just one option for borrowers to raise the capital needed to grow their business, while also providing visibility and strong returns to the lender.

PIK your moment

That being said, the tool has a fixed lifespan. Payments can’t be put off in perpetuity, so it’s important that everyone enters into a PIK arrangement fully aware of the potential risks.

For businesses with less predictable cashflow, or for those without a clear path to generating future income, this can create significant repayment pressure when the loan matures. In the worst cases, what looked like flexibility at the outset can become an unsustainable debt load further down the line.

Equally, some lenders will remain cautious about offering PIK – particularly if they believe it is being used to paper over existing financial stress. That means availability may depend as much on the confidence a lender has in a borrower’s strategy as on the mechanics of the loan itself.

Value of advice

As with any method of securing credit, engaging with a specialist advisor can be a vital way to help demystify PIK and shed light on the best way forward.

Our Debt Advisory team at FRP has extensive experience supporting both borrowers and lenders throughout the process. Our experts are well placed to explain the mechanics of PIK, test the assumptions behind cashflow forecasts and explore whether a full PIK, partial PIK or toggle arrangement makes the most sense in practice.

They can also stress test repayment models to ensure that any agreed structure won’t create unexpected pressure later.

Ultimately, PIK can be a valuable part of the capital toolkit, but it works best when applied with foresight. With the right advice, businesses can move beyond the headline flexibility and find the structure that genuinely supports their long-term growth.