Blackstone, Others Toggle To Help Preserve Cash

With liquidity at a premium, a number of buyout-backed companies are taking advantage of built-in PIK-toggle options in their financing packages to take on more debt instead of paying interest with cash. The move gives issuers a temporary reprieve, but it represents a risky course to take in an uncertain economy where credit is increasingly difficult to come by.

Of 56 sponsor-backed debt products with PIK-toggle options available to them, 20 of them, or more than 35 percent, have already elected to use their PIK provision, according to an analysis of data provided by Moody’s Investors Service and Standard & Poor’s. The list, for the most part, reads like a who’s who of the large-cap buyout world, including firms like The Blackstone Group, Kohlberg Kravis Roberts & Co. and Welsh Carson Anderson & Stowe.

Apollo Management tops the chart, with seven portfolio companies that have already elected to pay their interest in kind. Among these is chemical maker Berry Plastics Group Inc., and fashion accessory retailer Claire’s Stores Inc. Separate from the seven companies that have already opted to use their PIK, the New York firm has another four portfolio companies that have the PIK option at their disposal.

TPG, meanwhile, sponsors three companies with a total of four separate loans that have opted to PIK their interest payments. These include aluminum product maker Aleris International Inc. and hotel and casino concern Harrah’s Operating Co. (a co-investment alongside Apollo Management). Meanwhile, the firm has another four portfolio companies that have the option of doing so in the future.

Forty of the 56 sponsor-backed PIK-toggle debt products were launched to back LBOs in the peak year of 2007. Only four of the bond offerings backed 2008 buyouts, and of those four, three have already opted to PIK their interest payments. The sample is made up of 54 sponsor-backed companies that issued a total of 56 debt products with built-in PIK-toggle features.

Seventy-five percent of all the issuances that have elected to PIK their interest payments are unsecured notes, which sit toward the bottom of the capital structure. However, the phenomenon may inch its way up the hierarchy of debt in companies starved for cash. Meanwhile, seven of the 11 high yield issuers that elected to exercise their PIK option over in the previous two quarters have subsequently faced either downgrades or a change to a negative outlook, according to Moody’s. Seventeen of the debt instruments in our sample are second-lien loans or senior term loans, three of which have not yet opted to PIK their interest and another 14 whose PIK status could not be confirmed.

“If we head deeper into a recession it’s likely that companies with a PIK toggle option higher in their debt capital structure—as part of senior secured loans rather than unsecured notes—will elect to PIK interest to preserve cash and strengthen their balance sheets, especially as earnings expectations worsen,” said Randy Schwimmer, senior managing director and head of capital markets at New York-based mid-market lender Churchill Financial.

While companies can temporarily hide from their interest payments, one thing they can’t escape is the fact that while they are PIKing, the principles on their bonds or loans are growing. When the company eventually has to resume its cash interest payments, it will likely be faced with even larger interest payments due to the inflated principle. One lender based in the Midwest likened it to “prolonging the problem and delaying the inevitable.”

The source added that from a lender’s perspective, the PIK option can be a doubly bad deal. “It’s basically an instance of shifting the risk to the lender,” the source said. “If the company does default [after it can no longer PIK], then the lender has lost out not only on the principle repayment, but on the interest payments as well.”

The PIK-toggle feature really came into vogue in the 2005 to 2007 timeframe, when leverage was abundant and the lenders appeared more interested in the quantity of deals than the quality of them. For a predetermined amount of time, the borrower-friendly feature typically gives issuers a number of choices when it comes to paying the accrued interest on their loans or bonds. These choices include:

• Paying the interest in cash;

• Paying the interest “in kind,” which simply adds the amount of the interest payment to the principle amount of the loan;

• Or paying the interest half in cash and half “in kind.”