Despite the now two-month old rising stock and some signs that the frozen credit markets have unthawed, bad news continues to pour out of the credit markets. This morning the Wall Street Journal reported that a number of companies that issued debt with easy terms are now making use of those options to conserve cash. In particular, at least seven companies have exercised the option on $2.4 billion in bonds that lets them make interest payments by issuing additional debt instead of shelling out cash.
The PIK-toggle was extremely popular with private equity borrowers in the height of the buyout boom, and there were few banks that could resist offering it to the big buyout firms that were spilling deal fees like a oil-tanker in Alaska. They foresaw the cash-management advantage it would give them, allowing them to preserve capital when times were tight or threatening to tighten. With a pull-back in consumer spending widely anticipated--consumers have been going so strong for so long but plummeting confidence, rising prices, dropping home prices and credit card debt are thought to start dragging down spending soon--it makes a lot of sense for companies like Claire's, the costume-jewelry retailer taken private a year ago by Apollo, to conserve cash.
Of course, investors holding the bonds are howling. More importantly, with the bonds kicking back additional debt instead of cash, the PIK-toggle could put further strains on the credit market. Investors already stuck with bonds trading at distressed debt prices are unlikely to be willing (or able) to lend into new deals. Without cash coming in, there's less to push out, meaning the PIK-toggles could extend and deepen the credit crisis.
PIK and Roll: Companies Seize On Perks of Loose Lending Terms [Wall Street Journal]
Posted by guest , May 19, 2008 11:57AM
:) told ya so
Posted by Anal_yst , May 19, 2008 12:37PM
Ha ditto
Posted by GinNTonic , May 19, 2008 12:53PM
old news
http://blogs.wsj.com/deals/2008/03/26/debt-junkies-realogy-pays-off-debt-with-yet-more-debt/?mod=WSJBlog
Most of these guys have been trading in the 50s - 60s since February
Posted by Pro_Forma , May 19, 2008 1:38PM
I'm skeptical as to the actual magnitude of any cash impact on the holders of the PIK notes. Certainly the toggle represents a negative signal as to the quality of the credit - but it's not like these were 5 year straight line ammort notes to begin with (most that had any required paydowns were on the order of 1% per year), so the actual impact of reduced cash flow seems overstated.
Posted by Anal_yst , May 19, 2008 1:44PM
@ Pro_Forma
I think the signaling effect that co's are in a position (in the current environment) where if utilizing the PIK feature is the best decision, its a harbinger of (bad) things to come...
Posted by IA , May 19, 2008 2:02PM
That's pretty much the definition of a negative-convexity investment, no? When times are bad, you stop getting cash out of the trade as the PIK begins to toggle. When times are good the sponsor makes a 40% IRR and you get your modest fixed income return.
Posted by Pro_Forma , May 19, 2008 2:30PM
@ Analyst
That was my point. Agree that its a negative signal / leading indicator.
Didn't agree that the cash impact to noteholders would as material / meaningful as was portrayed in the DB write-up.
Posted by guest , May 19, 2008 2:36PM
This is (and always was) a cheap way for these highly leveraged firms to incrementally increase their leverage/borrowing capacity. And pretty cheaply I might add! Who else would give them money?
There are usually no performance triggers that would either create or require the PIK to be triggered, just choice by the financial sponsor...
It may or may not say anything about immediate financial problems at a firm. Instead, it can reflect good financial management by the borrower to keep liquidity and flexibility during the credit crunch.
Posted by Pro_Forma , May 19, 2008 2:43PM
PIK toggles generally aren't automatically triggered by changes in a company's financial standing, but for all intents and purposes the change is usually a product of more than "good financial management".
Even at the simplest level, the interest rate on debt that gets toggeled is usually significantly higher (e.g., by 400 to 500 bps). At my fund we've only used it when the alternative would be to trip over a debt covenant (e.g., fixed charge ratios or maximum debt / EBITDA multiples).
Posted by GinNTonic , May 19, 2008 3:04PM
Are you guys seriously trying to justify PIK toggles?
When the borrower toggles, the lender is essentially putting more skin in the game. In this economic environment with credits like Realogy or with leveraged levels of Univision, do you really think lenders feel happy about putting more money to work with these credits?
Posted by guest , May 19, 2008 3:21PM
@Pro_Forma: Wouldn't PIKing the debt increase the leverage ratio and bust the leverage covenant? Am I reading that wrong?
Posted by guest , May 19, 2008 3:36PM
If the frozen credit markets unthawed, that would mean that they were frozen. Again.
While I have reservations about saying that they are all that liquid again (or will stay as liquid as they may currently be) I don't think that's what you meant. :)
Posted by Pro_Forma , May 19, 2008 4:40PM
@ 3:21
It depends on the specific terms and conditions of said leverage covenants. In the cases where we toggled, it was in order to meet fixed charge coverage ratios that included cash interest but excluded PIK interest expense.
Posted by Pro_Forma , May 19, 2008 4:44PM
I've also seen companies flip the toggle and move PIK debt up to the Holdco level in order to avoid busting total debt / EBITDA covenants.
I'm sure the creditors were ecstatic.
Posted by GinNTonic , May 19, 2008 5:14PM
They probably were ecstatic. Assuming these PIK toggles were senior subs, and the senior uns / senior secs were on the same level, I would love to have the PIK debt as far away from me as possible.