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S&P: PIK-toggle notes may be harmful to debt-holders

PIK structures, frequently found in LBO-related debt offerings and currently being exercised by firms including KKR, Bain and Permira, may be staving off inevitable default to the detriment of debt-holders, according to Standard & Poor’s.

Pay-in-kind notes have gained popularity over the last several years, particularly their use in LBO-related debt offerings. But as companies backed by private equity firms including Apollo Management, Providence Equity Partners and TPG begin to utilise the so-called PIK toggles, they may simply be putting off default and harming debt-holders, according to a research report.

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.

“For firms with poor financial prospects, the issuance of PIK-toggle notes might only be delaying the inevitable and could likely deteriorate the recovery prospects for non-PIK debt holders,” according the report titled “Credit Comment: PIK-Tock, PIK-Tock, Delaying the Inevitable” and released by Standard & Poor’s Global Fixed Income Research.

Among a sample of 41 PIK-toggle notes totaling $22.9 billion in debt, four are paying in kind and three have announced their intention to do so. “Default risk is high and recovery prospects are low among our sample of PIK issuers,” said the report.

Standard & Poor’s assigned an average rating of 6 to the instruments in the examined sample, which translates to a negligible expectation of recovery in the range of 0 percent to 10 percent.

This is an ominous prediction for those holding the debt of many private equity-backed companies. Apollo has had four portfolio companies switch to payment in-kind: Momentive Performance Materials, Berry Plastics, Claire’s Stores and Realogy. Combined, the four portfolio companies’ issue amounts total more than $1.6 billion, according to Standard & Poor’s.

Also paying in-kind is Welsh, Carson, Anderson & Stowe portfolio company US Oncology.

Several other private equity-backed companies have been issued PIK-toggles but have not paid in-kind to date. HCA, acquired by Bain, Kohlberg Kravis Roberts and Merrill Lynch Global Private Equity for $33 billion in 2006, was issued $1.5 billion in PIK-toggle notes.

Freescale Semiconductor and Univision Communications were also issued $1.5 billion in PIK-toggle notes apiece. Freescale was taken private by The Blackstone Group, The Carlyle Group, Permira Funds and TPG for $17.6 billion in 2006. Also in 2006, an investor group including Madison Dearborn Partners, Providence Equity Partners, TPG, Thomas H. Lee Partners and Saban Capital Group acquired Univision for $13.7 billion.

“The last round of LBO-related defaults in the consumer products, retail and service sectors between 1988 and 1992 show that LBO-related defaults had lower recovery rates than non-LBO-related defaults during the same period,” said Standard & Poors although it remains to be seen whether that will be predictive for the current cycle.