R, a loyal reader, writes in to point out some other perspectives on PIKs. Quite sophisticated perspectives, it turns out. Readers will recall that we wondered after Payment in Kind (PIK) debt instruments which accept repayment of interest "in kind" with more debt instruments. In effect, the interest payments accrue until the maturity of the PIK instrument. I wondered aloud the other day if this didn't encourage more borderline lending and reduce the circuit breakers available when a firm starts to have problems paying its debt. Let's face it, if you have to turn a PIK Toggle on, it's because you can't pay your debt.
R prefers, however, to think of PIK as equity. Preferred stock, almost.
They don’t cross default, don’t sit round the table, are covenant free and have no security. Its equity all but for the maturity date.
R points out that the lender doesn't care if PIKs get loaded up like crazy. She's going to be paid off before the bulk PIK becomes due anyhow.
Sponsors, however, quite like the toggle. They want to stop, as R puts it and I paraphrase here, "sharing equity returns with that fucking PIK as soon as possible." It's not that PIK Toggles were invented to reduce debt payments so as to leave off the company at a delicate time, but rather to start paying off that PIK early if possible so as to boost equity returns to the sponsor.
The lender would far prefer to see that PIK Toggle switched off, in fact. Less cash out to the PIK holder, more reserve and hold-back cash for the lender with a big chunk of senior debt to look at and sign to herself "ah, look at that lovely cash cushion."
A quick example might be illustrative:
Let's assume we have a Neiman like transaction. $2.6 billion purchase price, About 25% of the debt structure is in a PIK Toggle. Let's assume about 25% of the purchase price is paid for in equity (a 3:1 debt to equity ratio) and that, for the moment, there's interest only payment on the PIK. Let's also assume that the PIK Toggle does not trigger an interest rate increase if switched on. We'll set the first year to 2007 and put a 8 year maturity on all the debt instruments. Further, let's assume that the sale price of the company is exactly the purchase price. (In other words, no multiple increase, no revenue/earnings increases- this should isolate the effects to the financial terms).
Just pulling the interest off of the PIK over the 8 year life of the debt boosts the equity returns from an IRR of 12.25% to 15.95%. You can see my error riddled spreadsheet on the example here.
Sayeth R:
Don’t get me wrong – I think PIKs are typically a toxic piece of paper to hold, but they are toxic only to the holder of the PIK and, if done wrong, the sponsor. The audience for such paper is a small and fully market savvy group; they know the risks – the odd cowboy hedge fund excluded.
