Private equity titans are dusting off an old gambit to cope with the rising cost of interest on their leveraged buyout loans: Don't pay cash.
Instead, they're making payments with more debt, preserving liquidity for now with the promise of a bigger payoff later when the debts mature. Those "payment-in-kind" loans don't always come cheap — the annual interest runs as high as 16% — but lenders and borrowers are wagering that they'll refinance when rates come down long before the due date.
Private equity firms ranging from Carlyle Group, Vista Equity, BC Partners, TPG, Cinven and One Rock Capital Partners are using PIK to buy or refinance companies that otherwise might struggle to carry heavy LBO debt. In turn, it's a boon for direct lenders that offer PIK financing, such as Apollo Global Management and Ares Management, which get an edge over Wall Street banks because PIK debt is harder to sell in traditional syndicated markets.
Collectively, the loans are injecting life into deal markets where activity is near the lowest in at least a decade, while papering over the cash shortfalls that some privately held companies are facing until times get better. Or at least, that's the presumption.
"PIK is being used more and in unique ways," said Randy Schwimmer, co-head of senior lending at Churchill Asset Management. "When interest rates go back to more normal levels, then there will be much less need."
The risk, of course, is what happens if rates don't go back to normal anytime soon? The supposition about early refinancing could be shredded if "higher-for-longer" scenarios come to pass, sticking borrowers with double the debt they originally took out in as little five years, or triple after eight years, which is about how long a typical PIK loan might last.
"The inherent issue with PIK debt is that it is issued explicitly because the underlying company does not believe that it can service its current debt load," said Scott Macklin, head of liquid leveraged loans at AllianceBernstein. "Any buyer of PIK debt is making a bet that the company's operations, debt load and/or interest costs will improve."
It's hard to pin down how much PIK is circulating because private loans aren't always reported. Bloomberg's database tracks at least $73 billion outstanding on various types of PIK borrowings — almost all of it rated below investment grade and some with coupons topping 20%. In some versions, a PIK issuer can opt to pay cash if they've got it, or "toggle" to pay in kind when liquidity is tight.
Among the latest financings, Carlyle is considering a PIK option on a $2.6 billion loan as the firm pursues some units of Medtronic. The borrower gets the choice of paying half the spread in PIK. In Europe, after Iris Software went on the auction block and lured the likes of Blackstone, EQT and KKR, private lenders offered about £250 million of PIK debt in the £1.25 billion financing package.
Drexel's heritage
PIK-paying debt has been around for decades, championed in the 1980s by firms like Drexel Burnham Lambert for borrowers with less than stellar credit. In normal times, PIK was part of deeply subordinated products, unsecured bonds or mezzanine debt, or used as a helping hand for seriously distressed companies.
Now, though, "PIK is becoming more mainstream," said James Reynolds, global co-head of private credit at Goldman Sachs. Senior debt and "unitranche loans," which have historically been 100% cash, are giving borrowers the flexibility to PIK all or part of their interest bills, Reynolds said.
They need it, because buyout math is getting harder. With benchmark rates hovering near their highest since 2007, an LBO with typical terms and debt that was easily affordable two years ago could have negative cash flow today. That makes PIK an attractive option if the loan is indeed refinanced early in its life.
A senior first-lien loan with a PIK option might mean paying an extra 25 to 100 basis points. A mezzanine PIK toggle debt can command 300 to 400 basis points more, which means a 14% to 16% yield. At that rate, the total owed can balloon parabolically after a few years, potentially putting the company's solvency in doubt.
Earlier this year, private lenders including Apollo, Blackstone and Oak Hill Advisors were in the pole position to win a $5.5 billion loan for Carlyle's acquisition of a stake in Cotiviti, edging out Wall Street banks by offering PIK. The M&A deal ultimately fell apart for other reasons.
More recently, HPS Investment Partners beat out JPMorgan Chase to handle a $1.65 billion loan for One Rock's buyout of packaging material maker Constantia Flexibles. One reason was HPS's deal allowed a small portion of the interest to PIK, something JPMorgan didn't offer.
While pay-in-kind loans are built to be temporary, some proposals are a bridge too far. Vista Equity Partners sought to refinance nearly $6 billion of debt at fintech firm Finastra in hopes private credit would provide as much as $2 billion in a PIK-paying junior loan. There weren't enough takers, and Vista had to pony up $1 billion of PIK preferred equity to complete the deal.
Choosing PIK
Credit raters sometimes take a dim view of the genre. "In our rated universe, PIK generally indicates distress and is often identified as a default," said Christina Padgett, associate managing director at Moody's Investors Service. "As private credit can have a wider range of return criteria, PIK can be considered more favorably. However, it is expensive for the borrower, so it is my impression that for issuers going this route, it is still about conserving cash."
Nevertheless, higher-for-longer rates might mean more PIK is coming. When private equity barons get their mojo back and buyouts return in force, PIK demand could be the highest ever, said Michael Small, KKR's head of European private credit.
There's also a growing need to refinance portfolio companies carrying leveraged loans, according to Alan Schrager, senior partner at Oak Hill Advisors. "We have seen a few opportunistic refinancings to clean up capital structures, but we are going to hit a huge wave of these transactions in the next year as existing indebtedness matures," he said.
About half a trillion dollars of leveraged loans are due through 2025, according to S&P Global Ratings, including junk-rated issuers who barely earn more than their interest payments or whose cash flow is already negative.
"So long as interest rates are still high, I don't think all of the current issuers can refinance themselves using traditional senior debt," Small said. "They're going to need something else. And in a lot of instances, that 'something else' might be PIK. Even if only 10% of that requires PIK, that's a huge opportunity."
