Latest Sign of Hot Market: PIK Toggles

PIK toggle notes, a common feature of the credit boom that give issuers the option of paying interest with more debt, rather than cash, are making a comeback

Unlike the first wave of payment-in-kind notes issued in 2005 and 2006, which were used to fund leveraged buyouts, the latest crop is being used by companies already owned by private equity firms to finance dividend payments.

“This type of PIK comes back in a hot market,” said Richard Farley, a partner in the corporate practice of law firm Paul Hastings.

Dividend recapitalizations themselves are nothing new: they’ve been a major source of bond and loan issuance this year. Private equity firms are having difficulty cashing out of their portfolio companies by taking them public, and having these companies issue new debt to pay dividends offers sponsors another way to realize a return on their investment.

“The IPO market is not all that robust, given all of the dry powder private equity firms have and how robust the leveraged debt markets have been,” Farley said. “It’s been a head scratcher for a year and half. In the $50 million to $200 million Ebitda range, LBOs are still pretty active, it’s just the larger deals we’re not seeing.” 

The bulk of this year’s dividend recapitalizations have featured additional loans and plain-vanilla bonds, rather than PIK toggle notes. These companies had enough earnings and cash flow, relative to their debt load, to borrow additional money without running afoul of covenants on the existing debt.

However, some companies may have difficulty issuing additional secured debt because of restrictions on what they can do with their excess cash flow. Farley said PIKs, which are issued at the holding company level, offer a get-around: the issuer can elect to issue additional debt in lieu of interest, if necessary, until the bonds issued by the operating company become callable, allowing the sponsor to recapitalize the entire company.

“It is another mechanism for sponsors to get an actual return on investment, the same as a dividend loan, doing an IPO or reselling the company in the secondary market," said Jamie Knox, a partner in law firm DLA Piper’s corporate and finance group.

The 14 dividend recaps in the third quarter included two PIK toggle offerings, according to an Oct. 16 report by Moody’s Investors Service. Emergency Medical Services issued $450 million of PIK toggle notes to fund a dividend to sponsor Clayton Dubilier & Rice, while IDQ Holdings issued $45 million of senior secured PIK toggle notes to fund a dividend to its sponsor, Castle Harlan.

The trend has accelerated in October. Petco Animal Supplies sold a $550 million PIK toggle note in connection with approximately $600 million distributed to shareholders, including private equity sponsors TGP and Leonard Green & Partners. Similarly, Pharmaceutical Product Development, sponsored by Carlyle Group and Hellman & Friedman, announced a $525 million PIK toggle offering, and Jo-Ann Stores, also sponsored by Leonard Green & Partners, priced a $325 million PIK toggle offering.

It goes without saying that PIK toggle notes are highly risky. They are typically structurally subordinated to the debt and non-debt obligations of the operating subsidiary, according to Moody’s. (Although the holding company issuer in many cases is required to pay interest in cash to the extent it is allowed to do so under restricted payment covenants.)

The Emergency Medical and Petco, PPD and Jo-Ann Stores notes were each rated Caa1, while the IDQ notes were not rated.

Nevertheless, investors are once again receptive to these offerings. “There’s a continuing thirst for yield, and this is a product that gives investors incrementally more yield than they can get in the rest of the high yield space,” said Knox. “Under present market conditions where the Fed is telling you ‘call us in a few years if you’re interested in actually earning interest on government debt,' people are looking all over the place for long-term yield.”

Petco’s five-year PIK toggle had a coupon of 8.5% and was issued at a discounted price of 99.5% of par to yield 8.624%. Jo-Ann Stores’ seven-year issue sported a coupon of 9.75% and priced at a discount of 98.76%. 

Farley said buyers of PIKs “weigh more toward the hedge fund crowd than a typical high yield bond or loan mutual fund crowd, but it’s just matter of degree.”

There’s another cost to this additional leverage. Moody’s said in its report that dividend deals of all types, not just those featuring PIK toggle notes, have weakened credit quality among rated companies. It downgraded the corporate family ratings of 27% of the issuers doing dividend recapitalizations in the third quarter, up from less than 15% in the first half of the year.

Knox said continued issuance of PIK toggles to fund dividends “is dependent on the equity market for new private equity portfolio company issuers being lukewarm and the interest rate environment being conducive to fixed-rate debt… It’s not obvious what’s going to disrupt this.”—AB