PIKs return, but it’s different this time

  • Issuance rebounds after post-recession slump
  • New deals come at later stage of ownership
  • Issuers remain just as leveraged as before

Through the end of August, rated U.S. non-financial companies have issued 13 PIK bonds totaling $5.1 billion, compared with 14 totaling $5.8 billion in all of 2012, Moody’s said in a report published on Sept. 26.

That is still a long way from the credit bubble era, however. Moody’s recalled a report it published in November 2008 that included 63 PIK toggle deals, most of them in the period from 2006 to 2008, with $34 billion in face value, more than triple the rate of issuance since the beginning of 2012.

“One thing has not changed, however: Today’s PIK issuers are just as leveraged as their bubble-era predecessors, so these deals still present significant risk to investors,” wrote Lenny J. Ajzenman, the Moody’s senior vice president who was lead author of the report.

Many PIKs are issued by the portfolio companies of buyout firms and carry high pro forma debt/EBITDA leverage of 6x to 7x. But the new wave of PIKs, which allow issuers to make their semi-annual interest payments using additional PIKs rather than cash, differs from the previous generation in several important respects, Moody’s found.

Perhaps most important, the new PIK deals are coming at a later stage of the private equity life cycle for these portfolio companies. In the days of the credit bubble, PIKs often were a part of the buyout deal that brought the issuer into the sponsor’s portfolio. Today’s PIKs, Moody’s found, are commonly issued after the company has been paying down its debt for several years, often as a way to recapitalize the company and providing a return to the investors, while allowing the sponsor to retain future options for a later sale or IPO.

What’s more, today’s PIKs are shorter-term instruments, typically four to six years rather than the seven to 10 years duration that was common during the bubble era. They also impose greater restrictions, often requiring the companies to pay cash interest to the extent that they can under their loan covenants, where pre-recession PIKs gave the company greater latitude in making the PIK versus cash decision.

Then there is the role of the economy. In the last cycle, PIKs were used to do buyout deals at the peak of a heated market. In the deep slump that followed, as many as 32 percent of the instruments defaulted, Moody’s found. Today, with the economy showing slow but steady growth, that experience is not likely to repeat.

“However, in another economic downturn, the aggressive leverage in these deals would leave these companies vulnerable,” Ajzenman wrote. “Private equity firms, which sponsor many of the PIK issuers, would likely continue to use distressed exchanges to preserve equity value.”