The Wall Street Journal points to payment in kind options on debt agreements or payment in kind (PIK) "Toggle" debt as a sign that the power in the hands of debt issuers is substantial. The Journal wonders, are these tools helpful breathers for firms that stumble for a quarter or two, or dangerous multipliers of risk?
Both.
Payment in kind is the payment of interest on a debt instrument with more debt instruments (i.e. in kind), rather than in cash payments. In effect, the interest accrues and is paid at a later date (usually the maturity of the instrument). In my experience, non-switching PIK instruments usually sit below several other layers of more senior debt, and bear a higher rate of interest. This should be intuitive to Going Private readers who will recognize that, lacking interest payments, PIK instruments are riskier for a lender to hold. There is no canary in the mine for this layer of debt. No missed payment to warn the holder of an impending default and therefore less of an ability to monitor the debt.
PIK Toggle instruments turn off interest payments and switch to PIK interest at a particular time, perhaps at the option of the issuer. This was the structure of the example the Journal uses, in which Neiman Marcus was granted $700 million in PIK Toggles, the interest payments of which could be switched off at Neiman's option to reduce the debt burden on the company in a time of difficulty. The interest would accrue at a higher rate (9.75% v. 9.00%) when the instruments mature in 2015. Neiman would hardly be off the hook even if they flipped the toggle. They started off with $3.2 billion in debt so turning the PIK on would increase their cushion, but not eliminate payments by any means.
One assumes that the increase in interest rate on the debt in question would provide a strong disincentive to flipping the PIK on unless the situation were dire, and we might also assume that, since the PIK would only be activated if the company were nearing default on interest payments due to collapsing revenue or unanticipated costs, the lender would expect to have the debt paid via a refinancing on maturity (or perhaps a LIPO). (Certainly the cash would not be sitting in the company's coffers at that point).
Indeed, we can see that PIK toggle permits struggling firms to "live to fight another day" when they are staring default in the face, but this begs the question: should they be able to? After a fashion, a PIK Toggle bypasses the events that typically signal default and, by proxy, indicate that the firm has become a distressed. Though we may sympathize with management, giving them more rope to hang themselves and charging nearly an additional percentage point for the pleasure might not always be the best option, as opposed to taking the keys and imposing more drastic fiscal discipline via the debt recovery department of the lender.
The other thing that concerns me about the practice is exactly what Texas Pacific likes about it. To wit: ""This innovation was one factor enabling us to pay a more aggressive price." This should, of course, be read: "This innovation was one factor enabling us to assume much more debt that would otherwise have been prudent." Really, what the PIK layer did for Texas Pacific and Neiman was increase the amount of debt that could be assumed to beyond what would have been prudent if the interest payments could not be turned off.
Far less safety margin seems required when PIK instruments are used and it is quickly tempting to push the limit to win auctions. It is, perhaps, telling that, "Nearly every TPG deal since Neiman Marcus includes debt with the PIK toggle feature." It's easy to forget that the effect of a PIK Toggle is to dramatically increase the debt burden on the company at a time when it is already showing signs of difficult with the existing levels.
The good folks at GoldenTree Asset Management are mentioned poo-pooing PIK Toggles. Sub Rosa has done some work with GT folks and they do love their PIKs, at least in my experience, but they just don't toggle them much.
Used prudently, PIK Toggles seem like a decent tool to hurdle a speed bump or two in the road. I suspect, however, they cause some rather severe damage to the rims of the faster driving deals out there.
