Robust demand from investors chasing yield turned 2013 into a nearly unsurpassed year for high-yield “PIK” note issuance, with a record number of issues sold in the U.S. market, and overall dollar volume lagging only boom year records set in 2007 and 2008.1 The types and terms of PIK notes issued since the end of the financial crisis have evolved from those issued during the leveraged financing boom that preceded it. However, more remains the same than has changed. As in the past, factors such as the issuer’s position in the corporate structure and the business purpose of the note offering remain key drivers of the basic interest payment terms.
The Basics
PIK notes are high yield debt securities that allow or require interest to be paid “in kind” (“PIK”) in the form of additional notes or by increasing outstanding principal, instead of in cash. PIK notes fall into three broad categories:
- Mandatory or “true” PIK: The interest payment structure is established at inception. Interest is required to be paid solely in kind or through a combination of cash and in kind interest, and may shift to all cash at a given point in time, with no variation from period to period other than as scheduled at the time of issuance.
- PIK “toggle”: The issuer at its option can pay interest for any given period in cash, in kind, or 50% in cash and 50% in kind. Interest may become mandatorily payable solely in cash during later years depending on the tenor of the notes. The PIK interest payment option is commonly at a higher interest rate than cash interest payments.
- Contingent cash pay, or “pay if you can”: The issuer generally is required to pay interest in cash, but under certain specified circumstances – typically, when subsidiary level financing agreement restrictions prevent the issuer from obtaining the necessary funds from its operating subsidiaries – interest will be payable in kind.
Pre-Crisis PIK Notes
PIK toggle notes had a significant presence in pre-financial crisis leveraged capital structures, being issued primarily to fund large acquisitions and in some cases to pay for dividends or stock repurchases. The PIK toggle notes for an acquisition financing were typically issued by the same entity that incurred the senior secured facilities and any cash-pay notes, with the same guarantees as the other acquisition debt. Operating cash flow access accordingly was no greater a concern than for the rest of the financing. PIK toggle notes were typically included in these capital structures to provide the issuer with downside protection. There was generally no immediate concern about the issuer’s ability to service cash interest expense, and typically the initial interest payment, due approximately six months after issuance, was required to be paid entirely in cash. When the financial crisis hit, many companies with outstanding PIK toggle notes defensively elected to pay interest in kind in order to preserve liquidity in the face of the uncertainty.2
PIK Notes Today: What’s New (and What’s Not)
In contrast, PIK note issuances in more recent years have predominantly been of the contingent cash pay or “pay if you can” variety, typically issued by a holding company to fund a dividend or stock repurchase. Holding company debt of this kind typically does not have the benefit of upstream guarantees from operating entities and accordingly is structurally subordinated to debt at the operating entity level, which may constitute the bulk of the debt capital structure. The debt is incurred at a holding company level, without upstream guarantees, because of financing agreement restrictions at the operating entity level on the incurrence of the debt and dividend of the proceeds, and on guarantees of parent level debt. Because a holding company typically does not have its own operations, to service its debt it must rely on operating subsidiaries to distribute cash. However, these subsidiaries are commonly subject to financing agreement restrictions on distributing cash to their parent (as well as corporate law limitations). Where there are limitations on the amount of cash operating entities can upstream, contingent cash pay notes allow all or a portion of the interest payment due to be paid in kind, depending on dividend basket availability and other restrictions.
This construct is not new. High yield bonds began appearing in the market a decade or more ago with a contingent cash payment feature, providing that cash interest was payable only to the extent funds were actually available for distribution under a specified covenant exception in the operating company’s debt agreements and under applicable law. In recent transactions, contingent cash pay terms have commonly incorporated a detailed payment scale linked to a so-called “Applicable Amount,” generally consisting of the cash amount that the issuer’s operating subsidiaries are permitted to distribute under their most restrictive debt agreements, plus the issuer’s own available cash. In a few instances, contingent cash pay notes have also provided that, if certain operating entity liquidity measures are not satisfied, the issuer may opt to pay in kind. However, lack of operating entity liquidity does not typically relieve the issuer from its cash interest payment obligations and, like cash pay notes, failure to pay would be a default.
The Applicable Amount commonly incorporates thresholds that allow the issuer’s operating subsidiaries to preserve some restricted payment capacity for other purposes. The most common contingent cash pay terms provide for a PIK option that scales up as the Applicable Amount decreases below 100% of the required interest payment, in 25% increments.3 Like PIK toggle notes, most contingent cash pay notes require the issuer to make the initial interest payment in cash.
In many recent contingent cash pay note offerings, the “equity claw” voluntary redemption feature differs significantly from the standard for high yield bonds. A typical high yield equity claw provision allows the issuer to apply proceeds of an equity offering to redeem, or “call,” up to 35% to 40% of the original principal amount of the notes during all or a portion of the otherwise applicable “non-call” period, at a redemption premium equal to the interest rate, so long as a minimum principal amount remains outstanding (typically 50% to 65%). Many recent contingent cash pay notes, in contrast, allow all or a portion of the notes to be called for all or part of the non-call period, with no minimum residual outstanding requirement. In addition, in most cases the redemption premium is 2%, considerably less than the typical interest rate. These variations are commonly motivated by the prospect of a near term IPO or sale. In this type of PIK note offering, the issuer may finance a dividend in anticipation of a partial or total exit event, accelerating the sponsor’s return on its equity investment.
The Future of PIK Notes?
Leverage levels have been rebounding since the financial crisis, but to date, post-crisis acquisition financing structures typically have not featured PIK toggle debt. Because the PIK toggle feature typically comes at an economic cost, and has been viewed by the market as a product of pre-crisis froth, it is perhaps not too surprising that it has not been seen in more recent, lower leverage transactions. One notable exception was the 2013 financing of the secondary buyout of Neiman Marcus, which had previously issued PIK toggle notes in its original 2005 leveraged buyout. The new PIK toggle notes did include some limited changes to typical pre-crisis PIK toggle terms; most notably to limit the total number of pay in kind elections and to require cash interest to be paid for the first year after closing.
Whether the Neiman Marcus PIK toggle note offering presages a resurgence of operating entity level PIK toggle financings remains to be seen. It does, however, highlight the distinctions between PIK debt product categories, and makes clear that the flood of contingent cash pay note issuances in the last few years does not necessarily imply a dramatic recasting of PIK note terms. The shift instead has been driven by the different considerations involved in holding company level financings to facilitate equity related investment returns. While some terms have evolved, the fundamentals remain unchanged.
1 Fitch Ratings, Pay-in-Kind (PIK) Debt: U.S. Market, Credit and Payment Trends, 1 (January 21, 2014).
2 Fitch Ratings, Pay-in-Kind (PIK) Debt: U.S. Market, Credit and Payment Trends, Appendix 2 (January 21, 2014).
3 For example, if the Applicable Amount is 75% or more, 25% can be paid in kind; if it is 50% or more, 50% can be paid in kind; if it is 25% or more, 75% can be paid in kind; and if it is less than 25%, all can be paid in kind.