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NEW: Mr Banker

SmartCompany /

In matters of security over borrowings, there’s nothing like a little syntax to smooth a banker’s furrowed brow.

Payment in kind?

However flexible my principles, I hold my convictions firmly – and none more firmly than my view that the only innovation in financial management since 1927 has been around the development of new names for old ideas.

As I take no greater pleasure than from being proved correct (except perhaps from seeing colleagues fail), you can imagine the quiet thrill I experienced on hearing of a new term – PIK notes – on which to test my theory.

Of course at the time I gave no indication that I had no idea what a PIK note was, resorting as usual to the ever-faithful knowing nod. When the coast was clear, I turned to the internet to satisfy my curiosity.

I learnt that PIK stands for “payment in kind”. Not much clearer, except that I have always employed a binary classification for payments types; type 1 being cash, and type 2 being ‘other’. PIK clearly fell into the category of ‘other’.

Further research proved helpful. It emerged that PIK notes is a term pioneered by the innovative private equity types who have previously provided me with so many entertaining diversions from the (potential) daily grind of the work that the bank apparently believes I am performing.

Now, private equity operators borrow as much as they can from banks. Those banks, being banks, will only provide money on the security of a mortgage over the borrower’s assets. That debt is described as senior debt.

However, for private equity to gear to the eyeballs and thereby sidestep the unpleasant business of writing cheques to the taxman, they must borrow further.

That further debt is described as junior debt, although you will sometimes hear it referred to as “mezzanine,” which of course is a more reassuring word than junior. Either term, of course, being far more pleasant than “junk bonds.”

With the security being fully pledged against the senior debt, further borrowing is usually via unsecured notes – however that terminology is likewise a little confronting and typically the “unsecured” is silent, although one will also hear references to “commercial paper.”

As notes provide little or no security, from the lender’s point of view they are higher risk. Because return follows risk (or should) they pay a higher interest rate. Some lenders will provide funding at both the senior and junior levels, reasoning that the risk of the business failing is the same but the return on the junior level is higher.

By now, some readers are muttering impatiently: ‘yes, yes, yes, BoLR – but what is a PIK note?’

Well, I’m coming to that. A PIK note allows the borrower to make interest payment “in kind” – by issuing further notes.

In days of yore, such an arrangement was described as “capitalising interest” and was frowned upon. Said frowning arose due to lenders’ preference for funding assets that at least generate sufficient cash to cover the interest bill (look at this from the other perspective – if they don’t, why on earth is the borrower holding them?).

Once more the clever private equity chaps have managed to avoid said bankers’ frowns by the use of a metaphorical coat of paint and a shiny new name. And your correspondent may now drift into his afternoon nap, complacent in the knowledge that (if only in the small things) he was proven correct.

 

For more Banker blogs, click here.

 

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