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Observations
 
There's an ancient Indian parable about six very wise, blind men who went into town one day because they heard that an elephant was there and they had never come across one before.

One of the men touches only the elephant's trunk and thinks it must look like a strong rope; another feels only its leg and believes the animal must look like a tree; yet another touches only the tusk and thinks it must look like a spear. All six eventually come away with his own view of what it looks like - none of which bear any resemblance to the animal itself.

I like to tell this story because it demonstrates the importance of making sure that you have grasped the whole picture before reaching a conclusion from examining only some of the parts.

And that's what Observations is all about. Allied Capital's BDC business model and the private equity industry are unfamiliar to most investors, so I'm sympathetic to the wise men in the parable. To help investors understand the many parts of our company, I'll periodically discuss key issues affecting Allied Capital and the marketplace in which we do business. It's part of our on-going commitment to providing investors with a more comprehensive understanding of our company.
Understanding PIK| 05.17.02

Picking up on PIK

Add another acronym to the lexicon of financial industry terms you may want to know more about. This one's called "PIK" and it stands for payment in kind.

It's not really a new idea, as most farmers and many other people might attest. For them, it basically means that you receive a non-cash payment in return for some goods or services. In our industry, though, it has a somewhat different meaning: it's used to describe interest or dividend income that is paid by a borrower through the issuance of a new security, instead of through periodic cash payments. Let me quickly add that the lender does indeed receive cash when the new security is liquidated or repaid at the end of the loan term.

Here's a basic example of how PIK works:

Assume we lend a company $10 million. We charge the company 14% in current cash interest and 2% in PIK interest. To keep the example simple, let's assume we don't receive any warrants in the company and, as a result, our stated interest rate is 16% (or 14% plus 2%). Let's say the note is due in five years. We will earn interest income from that $10 million note as follows:

    Year 1 Year 2 Year 3 Year 4 Year5 Total
Interest
Note Balance $10,000,000 $10,200,000 $10,404,000 $10,612,080 $10,824,322 $11,040,808  
Current Cash Interest 14.00% 1,400,000 1,428,000 1,456,560 1,485,691 1,515,405 $7,285,656
PIK Interest 2.00% 200,000 204,000 208,080 212,242 216,486 1,040,808
              $8,326,464

The current interest, $1.4 million, is paid in cash as required by the note. The PIK interest, $200,000, is paid in a security and is added to the principal amount of the note, increasing that amount to $10.2 million after Year 1. We will receive the PIK interest in cash when the note is paid at maturity.

PIK and Compound Interest

As a mezzanine lender, we like to use a PIK feature because not only do we receive a new security in the portfolio company without having to deploy any more cash, but the PIK feature results in a compounded interest effect, thereby increasing our overall investment return. In our example the PIK feature increases our investment return beyond the stated 16% interest rate to an average annual investment return of 16.65% as shown below:

    Year 1 Year 2 Year 3 Year 4 Year5 Total
Interest
Note Balance $10,000,000 $10,200,000 $10,404,000 $10,612,080 $10,824,322 $11,040,808  
Current Cash Interest 14.00% 1,400,000 1,428,000 1,456,560 1,485,691 1,515,405 $7,285,656
PIK Interest 2.00% 200,000 204,000 208,080 212,242 216,486 1,040,808
              $8,326,464

Effective annual interest rate		 16.00% 16.32% 16.65% 16.98% 17.32% 16.65%

At Allied Capital, we will frequently structure our loans with a PIK interest component when we want to improve the certainty of our investment return. For example, we may differ with a portfolio company as to the future value of their equity securities, and as a result we may opt to receive cash interest and PIK interest instead of cash interest and warrants to purchase equity. We have found that it is often better to take the contractually certain, compounded PIK return, instead of betting on what may end up to be a disappointing warrant value upon exit. For a mezzanine or private equity investor, PIK is often the best strategy if one wants to "lock-in" an investment return. An added benefit to PIK is that it is paid in a debt security that is senior in the portfolio company's capital structure to the equity securities we would have otherwise received upon exercise of a warrant. In other words, PIK notes have preference in liquidation to equity securities.

For a "real life" example, let's look at our loan to AbilityOne Corporation. We made a $10,000,000 loan to the company in September 2000. Our current cash interest rate was 12% and our PIK rate was 6.5%. (We took no warrants, so we charged a higher PIK rate.) The loan was repaid in full in cash in the first quarter of 2002, which included the receipt of $1.04 million from the collection of the PIK interest. Because the PIK compounded quarterly, our IRR on this investment was 20.1%, which is higher than the stated interest rate of 18.5%. In addition, we received a $1.1 million prepayment premium, which further enhanced our total return on this investment, bringing the total IRR to 27.0%.

PIK Accounting

Now that we have explained what PIK is and why we like PIK (and often prefer PIK to warrants), we need to explain how we recognize PIK income in our GAAP financial statements and taxable income. Essentially, the GAAP (generally accepted accounting principles) and tax treatment for PIK income is the same.

The GAAP rules and the tax rules for income recognition generally provide that if you receive tangible consideration for the sale of a good or performance of a service, you should recognize income for the value of the tangible consideration. So, although the PIK security received is non-cash, it does represent tangible consideration. It should therefore be recognized as income in the period in which that tangible consideration is received.

Let's see what this means in terms of the example we have discussed above. In Year 1, PIK interest is $200,000. We receive a security worth $200,000 (remember, the amount is added to the principal of the note) and we report the $200,000 as income during Year 1.

The exception to this treatment is if we have some doubt as to the ultimate collection of the PIK note. If that is the case, and if the value of the tangible consideration received is in doubt, then we should not recognize the PIK interest as current income. In fact, it has always been our practice to place PIK interest on non-accrual status if we have any doubt as to its ultimate collection over time.

What this Means For Investors

We know that our business can sometimes be difficult to understand, which is why we continually communicate with you on topics of interest. Regarding the issue of PIK, investors should know that even though PIK income is non-cash income during the period in which it is reported, we have received tangible value that will be converted to cash at the end of the loan.

Investors will also naturally want to know what effect our non-cash PIK income might have on our dividend payment, which is of course paid in cash. To analyze the effect of non-cash PIK income on our cash flows from operations, one must remember that for every dollar of non-cash PIK income we also increase our investment portfolio by $1 without having to invest any cash. Thus, the non-cash income and non-cash investment offset each other and have no real impact on our cash sources and uses from operating activities. Our portfolio and business generate substantial cash flow from operations. If you look at our "Consolidated Statement of Cash Flows," you will see that if you exclude money that was used for new investments (which does require new debt and equity to fund), Allied Capital generated cash flow from operating activities of $331million, $495 million and $420 million in 2001, 2000 and 1999 respectively.

We hope that this piece helps to explain to investors why we think that PIK is a valuable investment tool - one that has been used for decades by virtually every mezzanine and private equity player in the industry. It has served Allied Capital well over the years, and we will continue to structure future investments with PIK features. We will also continue to be vigilant to only recognize PIK income in our earnings when we believe we have received tangible value that will be ultimately collected.