Interview Question - PIK Interest Accounting

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During the technical interview portion, I was asked how a PIK note would flow through all the statements. Let me know your opinion on the below answer. Let's assume that it is a $100mm note with 10.0% interest.

Paid In Kind Interest Impact on the 3 Financial Statements

We review below the impact of a $100mm PIK note with 10.0% interest.

Income Statement:

  • Interest expense must be recorded (regardless of the fact that it is not being paid out in cash - interest expense up $10
  • More interest expense results in a income tax shield of 4 dollars assuming a 40% tax rate. This results in a tax expense that is lower by $4
  • Net Income is down by $6

Statement of Cash Flows

  • Net Income is down by $6 from the income statement
  • PIK interest is then added back as it is not a cash expense (paid out in the form of additional debt)
  • Net Cash is up by $4

Balance Sheet

  • Assets side of the balance sheet is up by $4 due to the cash flowing in from the statement of cash flows
  • Liabilities side of the balance sheet is up by $10 assuming that there is additional debt principal issued for the interest payment
  • Shareholder's Equity is down by $6 flowing in from net income on the income statement

What is Payment-In-Kind Interest?

"Paid-in-Kind" or "Payment in Kind" interest is a type of security that pays its interest or dividend in the form of a more of the principal form (IE bond principal or equity). This is preferred for companies that do not have / want to use cash to make payments to investors.

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Comments (34)

 
Feb 28, 2009 - 7:13pm

I'm pretty sure even though the PIK interest is non-cash, it shows up as an interest expense during the year accrued. The revenues generated during the year required the PIK expense, so regardless of when or how it will finally be settled in cash, the expense should be recognized as it accrues.

 
Mar 1, 2009 - 4:39am

True. PIK loans have no immediate interest payable. In other words, cash is not affected in terms of PIK interest payments until repayment of the principal. But then what is cash interest and PIK interest?

I know PIK interest (a very small fraction of the total interest) is added onto the principal. But what is cash interest? How do they affect the 3 statements?

 
Mar 6, 2009 - 4:09pm

Cash interest just flows through the statements as any other cash item...

And the way that ibanker26 described the accounting for PIK interest is correct

​* http://www.linkedin.com/in/numicareerconsulting
 
Mar 9, 2009 - 11:27pm

All mentioned by ibanker is correct except BS changes. mlamb93 got this right...interest payable remains unchaged and the loan principal on the balance sheet increases by 10mm.

Think of PIK as interest that was "paid" to and simultaneously "borrowed" from the lender (of course, no cash is exchaged). The end result is an increase in the lender's principal position in the company.

 
Mar 10, 2009 - 7:06pm

Actually, I agree with naija. I didn't read the original poster's response carefully enough.

​* http://www.linkedin.com/in/numicareerconsulting
 
Jan 22, 2013 - 1:46pm

PIK Debt (Originally Posted: 05/30/2009)

I have a PIK note that pays interest on a bi-annual basis. In terms of the balance sheet, would the debt increase bi-annually or would you also show the accrued interest in each quarter.

 
Jan 22, 2013 - 1:47pm

The correct method would be to create a bi-annual model with a debt and interest schedule that rolls up into the model. If the tranche of debt that PIKs isn't material to the overall capital structure then it may not make sense to spend the time building a bi-annual model, but it is up to you.

 
Jan 22, 2013 - 1:49pm

I'm assuming that your model is already quarterly, and you're trying to add a tranche of PIK debt that pays interest biannually?

If that's the case, the question is really what happens to the debt in a change-of-control situation mid-period. So if interest is paid on June/Dec basis and the company is sold in March, do the debt-holders get a half-period accrual? If you're modeling this for an actual deal or for an existing tranche debt, that information would be somewhere in the debt docs. There's probably a prepayment penalty too.

 
Jan 22, 2013 - 1:51pm

PIK Interest Help (Originally Posted: 08/14/2009)

Hey,

So I am doing a recap model and the company has alot of debt that has specific PIK period dates - for the revolver (technically would never happen), term loan, and notes.

So my balance sheet isn't balancing and Ive hit a wall. How do I handle PIK interest on I/S, B/S and CFS? Right now I have:

PIK int. expense for the period in int. expense for period
Accrued PIK interest accrues to my Accrued Interst line on B/S (the balances of my debt stay the same)

On CFS, I have my normal changes in Accrued Interest and Debt. In my cash flow ops, do I add back Non-cash PIK interest for the period?

Any help appreciated. Thanks

 
Jan 22, 2013 - 1:53pm

PIK notes in LBO (Originally Posted: 08/10/2010)

I have two questions about PIK equity in an LBO.

  1. When PIK equity accretes:
  • IS: No change
  • CF: Add back amount accreted, which would increase your cash balance
    But in an LBO use everything above min cash to pay down debt, so your debt balance is down incrementally by the accreted amount
  • BS: Debt is down by the accreted amount, equity is up by the accreted amount, so it balances.

Is that flowing properly? What about when the PIK equity doesn't accrete? Just add non-cash interest expense?

  1. HoldCo PIK

Either PIK equity or PIK note, my question is, if there's a PIK in a HoldCo, does that flow into the statements of the OpCO? If so, how would that work?

Thanks for anyone's help!!

 
Jan 22, 2013 - 1:54pm

tuaj:
I have two questions about PIK equity in an LBO.
  • IS: No change
  • CF: Add back amount accreted, which would increase your cash balance

You mention 'adding back' the amount accreted, but what are you adding it back to with no change in the income statement?

The PIK interest is accounted for on the IS the same way as a preferred dividend. Net Income - Preferred Dividends (PIK or otherwise) = Net Income Available to Common. You hen add back the non-cash amount of any dividends (the PIK amount) to Net Income on the CF. This causes a reduction in Retained Earnings (lower Net Income) and an increase in the Preferred balance.

Not sure I understand the second question.

Hope this helps.

 
Jan 22, 2013 - 1:55pm

Agree with SCLID on the first question.

On #2

You don't account for Holdco's debt in Opco's financials... OpCo only pays a dividend (known as dividend leakage) to holdco so it can meet its interest obligations (amounts governed by restricted payments clauses in the credit agreements). As far as opco is concerned, it is not a direct borrower, only an guarantor and as such, it does not have to account for the parent company's debt.

You only see these two (opco & holdco) in TopCo (or holdco, whatever the case may be) when it consolidates the financials for all subsidiaries.

 
Jan 22, 2013 - 1:59pm

PIK Notes (Originally Posted: 01/28/2012)

How do they flow through financial statements for a company that has them?

Do the long term liabilities just assume to be increased every year as the pik accrues? How does the interest work, is the interest paid on the principal, or as the principal increases as pik increases, is the pik paid on the new increased principal?

 
Jan 22, 2013 - 2:00pm

Accounting-wise, treatment is the same as any noncash expense. Interest is based on principal, which increases every year as the interest payments are rolled onto the principal. So say at the outset you have $100 in PIK debt at 10%, year one the interest expense is $10, principal goes up to $110. Year two interest expense is $11, etc...

 
Jan 22, 2013 - 2:03pm

PIK interest will show up on IC because it is accrued during the year. It is then added back on the CF because PIK interest is not paid, but rather the interest is added to the original principal, thus increasing the level of debt on the BS, and the entire loan will be paid off at maturity.

"They are all former investment bankers that were laid off in the economic collapse that Nancy Pelosi caused. They have no marketable skills, but by God they work hard."
 
Jan 22, 2013 - 2:05pm

PE Case Question -- PIK Preferred and Seller Note (And Returns) (Originally Posted: 03/04/2013)

Got a sample PE case from a friend of mine and had a couple of questions.

The case is laid out as a majority recap financed with:

Senior bank debt,
Sponsor participating preferred with both PIK and cash annual dividends (80% common equity ownership)
Seller note

Owner in turn gets similar participating preferred with both PIK and cash dividends (20% of common).

Owner also receives an initial cash payment, and will hold the seller note.

Couple of questions here:

1) How would I account for the PIK and Cash preferred dividends in the Income Statement / Cash Flow Statement? I would assume that the cash dividend would just be taken out in the cash flow section, thus reducing FCF available for debt payment. But then how would i account for the PIK preferred? It's not an expense, so no tax shield, but it seems like it should be included somewhere.

2) I'm not totally sure how to calculate the returns either: In general, the exit will be based on an EBITDA exit multiple. Subtracting the senior debt, seller note, preferred + accrued preferred divs and adding cash will get to the common equity value, which will then be split 80/20% between the sponsor and owner.

In calculating the returns for the sponsor I included the initial cash by the sponsor as a negative in year 0, and then included the preferred cash dividend each year as an inflow of cash. In the final year, the sponsor then receives the final year of cash dividend, the principal + accrued dividends on the preferred, and then 80% of the common equity leftover.

Does that sound right?

For seller returns i included his portion of the preferred as a negative for the initial outlay (basically rolled equity i think). I then included his preferred dividends each year, and then the principal + accrued dividends on the preferred in the exit year, and then 20% of the common equity. Will the seller note factor into this return at all?

This whole preferred structure and seller note thing threw me off a bit, would appreciate any feedback!

 
Jan 22, 2013 - 2:06pm

1) PIK just adds to the principal amount each month/period, and is expensed on the IS, but added back to CFO (non-cash item). So if you have $100,000 note with 10% PIK, year 2's starting balance for the note would be $110,000 on the BS and the PIK expense would then be $11,000 (@10%).

2) Do you have an lbo model built or do you have a template? Much easier to do if everything is laid out.

What you have sounds somewhat right and no, you wouldn't include the seller note in the IRR of the equity component. Keep them isolated. If they ask for the net to the seller, then you add the interest from the note, equity value, dividends, etc.

 
Jan 22, 2013 - 2:07pm
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