What are some questions on PIK Interest that those of you in PE have seen or typically ask. I have been trying to answer the question "How does PIK affect IRR" but have been having trouble and am trying to figure out what else I should be focusing on with respect to PIK. Thank you!
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Most common one I know of is how does PIK affect the three financial statements and you should know how 50% PIK/50% Cash works as well as a 100% PIK interest. (It's basically the same as depreciation). To answer your question, it's a bit complicated. I would say that PIK raises the cashflows earlier in the period but reduces the final cash payment to equity holders so I would say it raises IRR.
Interesting - my intuition was that the compounding of the PIK on interest would grow faster than one's ability to reinvest but the time value of money does add an interesting nuance that goes against my gut feeling
PIK should always increase equity return - else it would not be used by PE. In fact, it always will enhance equity returns provided that PIK coupon % is below equity IRR w/o PIK.
To convince your intuition, try calculating equity returns in these two scenarios:
Y0: invest 100 equity Y5: exit 300 equity
Y0: invest 50 equity, 50 PIK at 15% pa Y5: exit for 300, but now pay down PIK principal and accrued interest first before making a payment to equity
Compare your returns. Do you now see the point of PIK? I hope you do :)
I think the above first answer is slightly inaccurate.
PIK almost always reduces IRR in a traditional LBO with a sale exit (all other variables equal), compared to CASH interest.
this is because there are no Cashflows in the interim period (one entry investment cash outflow, and then exit cash flow on sale). the PIK reduces that exit cash flow. although the COMPANY saves cash in the interim period, this doesn’t benefit the SPONSOR’s IRR.
if it’s PIK, a 10% PIK is always worse (higher cost) vs a 10% cash interest, because of the compounding.
when I did banking I’ve heard an MD say ‘PIK increases returns instead of a TLB structure’ and the immediate reaction from the PE megafund is ‘on what planet will it ever do that?’
Good news: both of us are right.
I think we need to articulate the question and clarify: does PIK increase returns compared to WHAT?
1) PIK absolutely does increase returns if it acts as an additional level of leverage above equity
2) PIK will decrease returns compared to an equivalent cash paying instrument because the compounding interest will erode your return
But in PE, PIK is used for 1), when all cheaper leverage options have been exhausted because we all agree it is an expensive way to add leverage. Not as expensive as equity though.
fully agree and was referring more to the very first post on this page that seemed mix up sponsor cash flow and company cash flow.
thanks for laying out the 2 scenarios clearly, very thoughtful.
to add to it, I think usually the practical scenario that usually happens is 2)? The processes I’ve experienced always first considers the maximum leverage from the cheapest tranche of debt > can the company Cashflows support paying interest? > if not maybe use PIK instead of the cheaper debt cash interest > if so how does this impact returns? totally agree that PIK is usually a very expensive financing option and the last thing sponsors go to (unless they absolutely have to).
Yes, I agree with you - you will exhaust your cheaper debt options first. That's why we see 3-4 different layers of debt in an LBO, and then PIK at the very bottom.
My example above, with equity and PIK, is just to demonstrate that if you are choosing between more equity, or equity / PIK - the latter combo should yield a higher equity return. This capital structure is utilised only for companies that can't afford any cash interest at all (e.g. new project in a resources sector, growth equity, etc.)
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