Moody’s: PIK-toggle debt led to more defaults

A new report reveals private equity-backed companies that issued debt with payment-in-kind (PIK) toggle features were significantly more likely to default or have their ratings downgraded.

Private equity-backed companies that issued debt with payment-in-kind (PIK) toggle features leading up to the credit crunch experienced a substantially higher rate of defaults in 2009 than comparably rated companies, according to a new report from Moody’s.

A study of 62 companies that issued PIK debt, the majority of which had private equity sponsors, shows that nearly 30 percent ended up defaulting, compared to the roughly 17 percent default rate among companies that did not issue this type of debt.

PIK notes, which allow borrowers to elect to pay interest by issuing more debt, gained popularity in the years leading up to the credit bubble, and were used by companies backed by private equity firms including Apollo Global Management, Providence Equity Partners and TPG Capital. The rationale behind PIK-toggle notes is that they can provide a company financing flexibility to avoid default during rough patches, benefitting all parties involved.

Even with the added flexibility, however, companies that issued PIK-toggle debt were more likely to either default or have their ratings downgraded, according to the study. A quarter of the PIK-toggle issuers that remain rated are at high risk of defaulting or requiring balance sheet restructuring in the next few years, the report says. Furthermore, about two thirds of the analysed companies that made a PIK election at least once experienced downgrades or defaults since their issuance date.

In October, Moody’s downgraded the corporate family rating of metal and plastic packaging company BWAY from B2 to B1, and assigned a Caa1 rating – one of the lowest speculative grade ratings – to $150 million senior unsecured PIK-toggle notes. Still, PIK debt issuances have been rare since the downturn, Moody’s says.

“I think that there’s a likelihood that we’ll see more [PIK issuances] in 2011 if the credit markets remain strong,” lead author of the report Lenny Ajzenman told PEO. “We do hear talk about more PIK issuances but we haven’t seen too many of them close at this point.”