A “payment-in-kind” (PIK) note (or loan) is a way for companies to borrow money. When issuing a bond, a company typically borrows a fixed amount of money, for a fixed period of time, and pays a fixed amount of interest every year. With a PIK note, rather than pay interest each year, the interest is rolled up (capitalised) and added to the principal (hence the name, payment in kind – you are being asked to forgo annual interest payments in exchange for a higher overall payment at maturity).
Clearly, PIK loans are riskier than traditional debt (in the jargon, they are a form of “mezzanine debt”), because the lender receives no cash back until the end of the loan period. They are also usually unsecured, and low in the pecking order in terms of repayment if the company goes bust. As a result, they tend to offer high interest rates.
There are also usually high early-repayment penalties (because lenders want to gain the compound interest from the loan, rather than see it repaid early). They are used by companies with high growth potential that would rather use their free cash for expansion and investment. The idea is that the high growth will be sufficient to repay the hefty interest bill at the end of the period. One high-profile example of a deal involving PIK notes going wrong is UK budget fashion chain Peacocks, which went into administration in 2012 (before being bought by Edinburgh Woollen Mill).
In 2005, a £404m management buyout of the company was part-funded by £110m in PIK notes, at an annual interest rate of 17.2%. Following the financial crisis, Peacocks was unable to refinance the deal. By 2010, the payment due had reached £301m, and by the time the company went into administration, the PIK liability was thought to be around £400m.