Treasury Today Country Profiles in association with Citi

PIK notes and loans

Payment in kind (PIK) instruments can increase debt leverage without using up cash flow as coupon payments are compounded and not paid in cash. During the past five years, PIK notes and loans have predominantly been used by private equity firms to fund dividend recapitalisations and to refinance or partially finance the cost of leveraged buy-outs. The appeal of these high-yield and, for investors, high risk instruments has led to the development of more complex structures.

PIKs are payment in kind notes or loans which typically do not provide any cash flows from debt issuer to lender until maturity. In contrast to mezzanine loans, for example, no portion of the interest has to be paid before maturity. Instead, interest accrues and is repaid upon maturity, or is prepaid in the event of a refinancing.

PIKs are generally either unsecured loans or deeply subordinated securities ranking just before equity in the capital structure. This means that, in the event of a bankruptcy, PIKs are the last debts to be repaid, making them a high risk instrument for lenders and investors. In order to compensate lenders for the risk, PIKs have to offer significant returns of 10%-20% per year.

Although PIKs have already been used as a refinancing method in the 1980s in the US, the increased private equity investment activity in the past five years has been the main driver for the surge in PIK issuance. Initially used to fund distributions to shareholders, PIKs are now also employed to finance leveraged buy-outs, acquisitions or the refinancing of junior instruments.

By 2007 more than €9 billion of PIKs had been issued in notes or loans in Europe, overtaking second lien instruments. However, the recent credit crunch has impacted on the market and some observers have predicted an end for PIK instruments.

Characteristics of PIK instruments

PIK instruments have several characteristics that distinguish them from traditional high yield instruments (eg bonds).

Return and interest

Payment in kind means that interest on a bond (or loan) is paid in a form other than cash. This can be in the form of accruing interest (compound interest), which is added to the principal amount and repaid at maturity. Alternatively the interest may be paid in the form of additional PIK notes or – less often – as warrants, which are notes that are convertible into shares in the company or a related company.

PIK notes have become very popular as no immediate cash flow is required prior to maturity to service the debt and interest payments are simply compounded or covered by the issue of new debt (which can be new PIK debt).

Non-call periods

Generally floating rate notes or bonds have a call protection of five years, which prevents the issuer from redeeming the instrument during that period. PIK notes generally have a much shorter call protection of between 3 and 18 months. Some PIK loans in the market even feature no call protection at all.

The call structure will depend on the intended use of the instrument. Often PIK financing will be used as a bridge financing to an IPO. The end of the non-call feature tends to indicate when the issuer expects to go public or sell the business and repay the PIK note or loan. Some structures feature a calling period at par value (face value) just after the non-call period. Other structures include a step-up (increase) of the coupon rate after a certain time period. The increased coupon is then often linked to performance indicators such as leverage tests.

Unsecured and unguaranteed

In contrast to cash-paying high-yield notes, which generally benefit from subordinated upstream guarantees from the operating companies, PIK notes are typically unsecured and unguaranteed. PIK notes are issued by the holding company or by a special purpose vehicle of leveraged issuers.

Security or guarantees would enable a lender to claim on restricted group entities other than the issuing entity. This is not the case with regard to PIK notes, which are structurally subordinated to senior or second lien debt and rank next to equity in the capital structure.

As a result, note-holders will only have an equity claim on the operating group and in the event of insolvency will rank behind all other senior debt claims including trade creditors, without being able to influence insolvency proceedings or the restructuring of the borrower.

Loans or notes

PIKs can come in the form of notes or loans. PIK loans tend to be subject to fewer disclosure requirements and regulations governing the marketing of the debt issue and are therefore faster to arrange. Some hedge fund investors may also prefer loans as they do not need to be marked-to-market in their financial statements. As a result, PIK loans have gradually become more popular than the issuing of PIK notes.

Investors

Hedge funds are the main investors in PIK notes or loans. Other investors may find it difficult to invest in instruments that do not feature any kind of cash income prior to maturity. Hedge funds are less limited in their investment choices and select PIK instruments because yield is more of a focus in their investment strategy than liquidity.

Further investors in PIK instruments include private equity firms and other high yield investors who are willing to take on high levels of risk in return for high yield. Due to the restricted investor base, the PIK market as a whole is very sensitive to sudden swings in sentiment.

Pricing/cost

While many of the European PIK notes are issued as fixed rate instruments, the majority of PIK notes are now floating rate instruments, which can also offer more flexibility with regard to non-call periods. The pricing of PIK notes has been comparable to – and is sometimes lower than – that of other subordinated instruments, such as warranted mezzanine. In the past a few companies have therefore refinanced mezzanine with PIK instruments.

Tenor

Traditional PIK instruments have a longer tenor than the longest dated group debt. This is generally between eight and ten years, but some deals have been issued with shorter tenors of five years. It is however expected that most PIKs will have much shorter tenors in practice, due to prepayment in the context of an IPO or a sale of the business within the first years of issuance.

Prepayments

Although the majority of PIK issues have been marketed as a bridge to an IPO, only a small minority has so far reached the IPO stage and been repaid with any funds generated by a public offering. Most PIK issues have so far not reached maturity or been refinanced by other means. Nonetheless, IPOs or refinancing remain the main expected form of prepayment or repayment.

Added leverage

The size of individual PIK issuance varies significantly in terms of both volumes and leverage. The size of individual PIK issues in Europe ranges from €25m to €1.67 billion, averaging at €500m. Generally PIK is attractive because it adds leverage without impacting on cash flow. PIKs have, for example, been used as a financing tool for leveraged buyouts because they enable the borrower to achieve higher leverage without paying cash interest on all of the funds raised.

PIK toggle notes

In addition to pure PIK notes there are now structures that pay a portion of the interest in cash and the remainder as PIK. Other instruments give the issuer the option to pay interest either in cash or as a PIK (ie by issuing additional PIK notes). These PIK ‘toggle’ notes enable the issuer to switch between cash and PIK interest repayments and thereby limit the cash flow required to service the debt when needed. While this will provide the issuer with added financial flexibility, the use of PIK will in most cases trigger a higher interest rate.

Uses

The first PIK instruments were used to finance dividends or repay shareholder loans. Increasingly PIKs have been used for other purposes such as partially funding LBOs, debt refinancing (including existing PIKs) or the buy-out of minority shareholders. Their main use of PIK to date has been the funding of dividend payouts.

Private equity firms, in particular, prefer the use of PIKs because the delayed interest and capital repayments enable them to retain as much cash as possible to develop and grow the business. The financial sponsor will typically have an exit strategy such as selling the business or carrying out an IPO. Any proceeds from such a transaction would then be used to repay (or prepay) the PIK.

Dividend recaps

Prior to the currently deteriorating credit environment, many private equity investors took advantage of low debt pricing and market tolerance of high leverage levels by refinancing or recapitalising. Recapitalisation has been a common method of passing dividends to sponsors by introducing further debt into the company.

By using recapitalisation to fund dividend payments, equity sponsors are able to extract equity from an investment just a short time after an initial acquisition, because the use of PIK notes allows the support of greater leverage at existing cash flow levels. This may lead to a more efficient debt structure and it reduces the exposure of the private equity investor to a company that becomes more highly geared. In this context it is important for the private equity investor to find the right balance between the greater burden of debt servicing at higher leverage levels and achieving the targeted return on equity.

LBOs

In a leveraged buy-out, PIK loans may be used when the purchasing price exceeds the leverage levels that lenders of senior, second lien or mezzanine debt are comfortable with. It may also be the case that the cash flow used to service more senior debt is not available for distribution to shareholders or to repay holders of PIK debt. Due to the high cost of PIK loans (both interest and fees) compared to more senior debt, private equity companies have to assess whether the use of PIK makes the LBO a viable investment.

Benefits and caveats

Financial flexibility

The main benefit for the issuer of PIK debt is the enhanced financial flexibility. More funds are made available without increasing the cash flows required to service the issuer’s debt, as there is no amortisation and interest is rolled up into additional principal or paid with additional PIK notes.

In addition, PIK debt enables an even higher level of gearing without curtailing the borrower and without altering the terms of senior debt facilities.

However, critics argue that when a company is in difficulties this method of finance results in far too much debt, while increasing the risk to investors. According to this view, PIK debt will often result in total debt levels that would not be sensible if all interest had to be paid in cash. PIK debt has therefore been indicative of companies with an already high debt burden which are facing a considerable amount of business uncertainty.

Depending on the viewpoint, PIK debt will either provide the company with the cash needed to recover or simply exacerbate the situation and multiply the risks involved.

Cost

The deep subordination of PIK and the lack of covenants, security or guarantees represent the highest possible credit risk for investors and of course this comes at a cost. The lack of regular interest payments makes it more difficult for lenders to monitor the debt. High interest margins reflect these risks as well as the uncertain recovery prospects for PIK debt, making it a viable financing instrument only for high-growth businesses.

Refinancing risk

While PIK notes do not require any cash to service the debt until maturity, the financial burden of repaying the debt at maturity is considerable. In particular, if an anticipated early prepayment fails because the company cannot be sold or go public, for example due to timing issues, the high cost of redeeming or refinancing PIK debt can become problematic.

Rating

Given the relative weakness of deeply subordinated PIK instruments, PIK notes are often rated below any existing cash-paying high yield notes. Although PIK notes tend to increase leverage and can be regarded as an aggressive financing technique, the structure of PIK debt will often not impact on the rating of the issuer’s other debt, provided certain conditions are met concerning credit support, maturity and enforcement rights with regard to the restricted and rated borrower group. As no permanent cash flow is required to service the debt, PIK notes enhance the financial flexibility of a company.

If PIK debt is used to refinance subordinated debt (ie mezzanine) this will even be seen as deleveraging the company. This is, however, not common practice.

Credit crunch

In the current credit environment the majority of market observers expect the number of PIK note issues to decline significantly and to consist mainly of roll-over transactions. In a report on leveraged loans in late 2007, Standard & Poor’s even pronounced PIK deals dead, given the credit crunch.

Meanwhile, a survey published by legal firm Norton Rose in September 2007, ‘Credit Crunch: When will liquidity return to the market?’ found that 68% of respondents thought it likely or very likely that the credit crunch would lead to less use of PIK loans. The survey notes that ‘In uncertain times, people have less appetite for riskier debt’ and suggests that consequently ‘simpler, more traditional structures will be preferred’.

Conclusion

PIK instruments provide an additional layer on the debt-equity continuum somewhere between second lien, mezzanine and equity. However, their high cost means PIK notes and loans are not instruments for mainstream companies. They tend to meet the specific needs of private equity investors as they can increase the debt leverage of their invested companies without adding to the cash flow needed to service the debt. This can make them suitable instruments for dividend recaps and LBOs, despite their high cost.

The benefits of PIK instruments in terms of financial flexibility will however be difficult to achieve in today’s difficult credit markets and only be available to high growth companies.