High-Yield Debt Issuers Trigger "PIK" Options
In the face of depressed earnings and a weak economy, a raft of cash-strapped private equity portfolio companies have stopped making cash interest payments to holders of their high-yield debt, electing instead to issue additional notes by triggering an option known as a payment-in-kind, or “PIK,” toggle. In February, Forbes Magazine reported that in recent months 23 companies had exercised PIK options on their high-yield debt.
Under the terms of a PIK-toggle notes indenture, an issuer can choose to pay accrued interest on its notes either in cash or by issuing additional notes, known as “PIK notes.” When an issuer chooses to pay interest in PIK notes, the annual interest rate for the notes usually increases by about 25 to 75 basis points. Generally, interest payments in PIK notes are reflected by increasing the outstanding principal amount of notes held by an investor in an amount equal to the PIK interest that accrued over the relevant interest period. Since PIK note interest payments are added to the principal amount of the outstanding notes, PIK interest – unlike cash interest – is compounded. At maturity, the issuer must pay its noteholders the total adjusted outstanding principal amount of the notes – including capitalized PIK interest – in cash.
During the private equity boom of 2005-2007, firms successfully negotiated senior and subordinated financing with strikingly permissive terms. Many senior bank loans, for example, were stripped of traditional covenants requiring borrowers to maintain certain financial ratios (such as Total Debt to EBITDA). The lenient terms on which banks were willing to fund senior loans, colloquially referred to as “covenant lite,” protected debt issuers from activating automatic default provisions merely by a deteriorating financial condition.
At the same time, investment banks discovered that investors’ appetite for high-yield corporate debt allowed them to underwrite notes offerings on more issuer friendly terms. Investors, it turned out, were willing to provide debt issuers flexibility in how they chose to make interest payments in exchange for increased returns. Adding a PIK toggle feature to standard high-yield notes indentures appealed to investors and private equity sponsors alike. Investors purchased PIK-toggle notes primarily because they offered an overall higher rate of return on a high-risk investment. Private equity sponsors negotiated PIK toggle options because it gave them a cash alternative to servicing at least some of their portfolio companies’ debt. Sponsors thought PIK toggle options would help protect their equity investment from economic downturns by reducing a portfolio company’s need for cash when restricted by liquidity constraints. PIK notes became so popular that by November 2008 around 47 companies, most owned by private equity firms, had amassed a total of $33.4 billion in outstanding PIK notes.
For sponsors of highly leveraged portfolio companies that require consistently high earnings in order to service their substantial debt obligations, PIK toggles were a creative way to mitigate a high-yield debt issuer’s risk of missing interest payments in the event that revenues declined. Indeed, PIK-toggle notes function like “interest lite” debt that allows companies to defer interest payments without incurring penalties, defaulting under the notes indenture, or breaching cross-default provisions in other financing documents. But the flexibility in financing provided by PIK notes came at a price: Moody’s Investors Service concluded that issuers of PIK-toggle notes in the years 2005 through 2007 typically paid 75 basis points more on their issued debt and received weaker corporate credit ratings than non-PIK notes issuers.
Exercising their rights under PIK toggle options to suspend cash interest payments can help high-yield debt issuers reduce the costs of servicing their debt in the short-term, but this financing strategy does not address highly leveraged companies’ long-term debt servicing needs. Most PIK-toggle notes indentures only permit issuers to make PIK interest payments for a limited time (usually five years), after which they are required to make cash interest payments. Companies that currently pay PIK interest to their bondholders and whose PIK toggle options expire in the next 12 to 18 months will be most vulnerable to defaulting on their debt if current economic conditions continue. Unless such companies can begin to improve operating results significantly, they may find it prohibitively difficult to resume quarterly cash interest payments.
