Pik Preferred Equity A Comprehensive Guide

Pik Preferred Equity is a type of investment that offers a unique combination of features and benefits.

Pik Preferred Equity is a relatively new concept, introduced by Pik in 2022, making it a fresh and exciting option for investors.

Pik Preferred Equity is designed to provide a stable source of income, with a fixed interest rate of 5-7% per annum, as mentioned in the article.

Investors can choose from a variety of investment options, including a minimum investment requirement of $1,000 and a maximum investment period of 5 years.

Pik Preferred Equity is a low-risk investment option, suitable for conservative investors who prioritize capital preservation over high returns.

On a similar theme: What Are Preferred Shares

PIK debt typically refers to a loan or bond where all or some of the accrued interest is capitalized throughout the life of the debt instrument. This means that instead of paying interest on the loan, the borrower adds it to the principal balance.

PIK loans or bonds are often issued by the holding company of the parent of the corporate group receiving senior debt, ranking behind senior secured bank debt but ahead of equity investors.

Explore further: Equity Debt Financing

PIK financings can be structured in many ways, but typically have the following features.

PIK debt is often used in place of cash payments, allowing companies to defer paying interest on a loan or bond.

This type of debt typically has a higher rate of return than senior debt to compensate for the deferred payment of cash.

PIK loans or bonds are usually issued by the holding company of the parent of the corporate group receiving senior debt.

The PIK debt ranks behind senior secured bank debt issued to the company, but ahead of equity investors.

PIK financings can be structured in a variety of ways, but these features are commonly found in this type of financing.

Recommended read: Cash Equity Trading

Participating Preferred securities are a type of exotic security that can result in much higher proceeds than Convertible Preferreds, especially at lower exit values.

They offer downside protection, meaning they accrue at a higher value than common equity at lower exit proceeds. This is because they receive both the converted value of common shares and the preferred value of the security.

Check this out: Common Share Equity

In a Participating Preferred, you get to participate in the common equity value, which makes it a much more attractive option than a Convertible Preferred, all else being equal.

At $400mm of exit proceeds, a Participating Preferred can result in $175mm in proceeds, which is significantly higher than a Convertible Preferred.

Participating Preferred securities are often given lower ownership percentages, which can result in a higher implied equity value, particularly for private companies.

This can be a strategy to juice the sticker price of an asset in the public eye, but it also serves as a reminder that high valuations can sometimes be flimsy.

A unique perspective: How Do You Buy Preferred Shares

Borrowers can explore flexible payment-in-kind (PIK) options to manage the delayed impact of higher interest rates. These options include converting a portion of senior debt interest to PIK, junior capital facilities that feature the ability to toggle between cash pay and PIK, HoldCo PIK notes, and preferred equity structures that may include a PIK dividend and equity upside for the investor.

Converting senior debt interest to PIK can provide temporary relief from rising interest rates. However, it's essential to consider the potential long-term consequences of this approach.

The benefits of junior capital facilities that feature cash pay and PIK options are that they can adapt to changing interest rates. This flexibility can help borrowers manage their cash flow more effectively.

Here are some key pros and cons of PIK preferred equity:

PIK debt is inherently riskier as it typically ranks behind other senior debt and is frequently structurally or contractually subordinated.

This means that PIK holders will only make a recovery to the extent that there is any surplus cash once the senior debt has been repaid.

PIK debt also requires lenders to assume additional credit risk from a borrower because the amount of the principal owed will grow over time.

A prominent example of this was the failure of retail fashion brand Peacocks, which issued PIK notes at 17.2% per annum, leading to a significant PIK liability.

By the time of its administration in 2012, over half (£400m) of its £750m total debt was attributable to PIK liabilities, which contributed to its demise.

PIK instruments carry limited rights on an insolvency or breach of covenant, and limited influence on how the underlying business is operated, or how restructuring discussions progress.

This can make enforcement steps of limited practical value, especially where the value of the operating group breaks in the senior debt.

Here are some potential pitfalls of PIK instruments:

Taxes can be a complex topic, especially when it comes to PIK Interest. In most cases, PIK Interest is tax-deductible, just like Cash Interest Expense.

However, there may be exceptions, such as when PIK Interest is attached to an "equity-like security." This can include convertible preferred stock or convertible notes for a startup, and the tax treatment varies by region.

To assume that PIK Interest is not tax-deductible, you can add a Deferred Tax line in the cash flow projections and set it equal to the PIK Interest multiplied by the Tax Rate.

A unique perspective: Convertible Equity Financing

PIK notes are debt instruments with fixed terms and call protection, and many equity-like features such as observer rights and carry tag along rights on exit.

They are generally unsecured and structurally subordinated in the debt capital structure, with security often limited to a pledge over shares in the issuer or a form of guarantee from the direct holding company.

PIK notes can be privately held or publicly traded on Stock Exchanges and through the Clearing Systems, ensuring ease of transferability.

There are two main types of PIK notes: stapled and semi-stapled to equity, which can affect how they are recorded and transferred.

Here are some key characteristics of PIK notes:

Preferred Securities, on the other hand, are a type of financing tool that blends elements of both debt and equity, offering an attractive yield to private equity firms without giving up control of the business.

They typically pay dividends, which can be in the form of cash or PIK interest, and are often used in private equity because they dilute total equity ownership less than common equity.

Preferred Securities are a type of financing tool that blends elements of both debt and equity. They sit above Common Equity but below Debt in a company's capital structure.

Preferred Securities typically pay dividends, which can either be in the form of cash or PIK interest. This makes them an attractive option for private equity firms, as they can provide a yield without giving up control of the business.

Companies may choose to issue Preferred Securities because they dilute total equity ownership less than Common Equity. Only Common Shares have voting rights and direct ownership of the business.

Preferred Securities generally have PIK (non-cash) interest, meaning there is no ongoing cash expense associated with them. This makes them a good option for companies with limited cash flow.

Investors may be attracted to Preferred Securities because they offer greater downside protection than Common Equity. They issue dividends, are higher in the capital structure, and often have a "liquidation preference".

Check this out: Where Can I Buy Preferred Stock

Here are some key characteristics of Preferred Securities:

Preferred Securities can be a good option for companies that need to raise capital without giving up control. They offer a unique blend of debt and equity features that can provide a yield without the ongoing cash expense of debt.

When dealing with PIK interest, it's essential to add it back to the cash flow statement. This is because PIK interest is not a cash outflow, but rather an expense that's reflected on the income statement.

You'll need to reverse the PIK interest on the cash flow statement, just like you would with depreciation. This is a crucial step to ensure your financial projections are accurate.

In the context of debt principal repayments, adding back PIK interest is particularly important. It allows the company to use its cash to repay debt, rather than letting it accumulate.

By adding back PIK interest, you'll get a more accurate picture of the company's cash flow and financial health.

A leveraged buyout model is a financial framework used to structure a deal, and it's essential to understand its components.

In a standard leveraged buyout model, the debt-to-EBITDA ratio is typically 5x.

The interest rate on the debt is usually 8%.

The debt balance is used to calculate the interest, and it's based on the beginning debt balance in each period.

In a leveraged buyout model, the deal is done at a multiple of 12x EBITDA.

A cash-free, debt-free leveraged buyout is a common scenario in these models.

The interest rate remains the same, 8%, even if the interest is 100% PIK Interest.

The beginning debt balance is used to calculate the interest in each period to avoid circular references.

A fresh viewpoint: Equity Internal Rate of Return

PIK interest reduces the IRR and multiple for the PE firm because it increases the Debt balance upon exit.

The improved cash flows from PIK interest accumulate to the Cash balance, but the final Debt balance increases by more than the final Cash balance.

This results in a higher Net Debt upon exit, which reduces the equity proceeds, IRR, and multiple.

The lenders' multiple changes with PIK interest, but the IRR does not, due to the "reinvest all proceeds at the overall IRR" assumption.

Earning 8% cash interest per year on the initial balance is the same as earning no interest but getting back the Initial Balance * (1 + 8%) ^ 5 at the end of 5 years – according to the IRR function.

Carvana entered a deal with Apollo Global Management to a $1.6 billion PIK loan in April 2022, which involved a series of investor-friendly provisions.

These provisions allowed the cash-tight car dealer to enjoy the benefits of a loan without having to make cash payments in the short term.

Flexible payment-in-kind (PIK) options borrowers might want to explore include: