The issuance of risky payment-in-kind (PIK) bonds will continue to surge in Europe in 2014, according to Moody’s, even though the stronger equity market gives private equity firms other ways to extract cash from their LBO investments.
Private equity sponsors accounted for eight of the nine European PIK transactions that Moody’s rated in 2013 – and six of the eight were used to fund a dividend.
“Despite the return of the IPO market, which allows private equity firms to sell their LBO investments, these firms will continue to use holdco PIK issuance as another way to return money originally invested in their LBO,” said Moody’s analyst Tobias Wagner.
The short non-call period of PIK notes, in which the debt cannot easily be repaid, means investors often see them as a bridge to an IPO or debt-market exit.
“In that regard, confidence in the sustained return of the IPO market may actually stimulate some PIK issuance, in the expectation of a near-term refinancing or IPO,” said Wagner.
According to Moody’s, PIK issuance in Europe has effectively doubled year-on-year since 2011. Issuance that year was just shy of USD1bn-equivalent; 2012 saw USD1.9bn-equivalent of deals; and last year saw a massive USD4.5bn-equivalent.
This figure includes a whopping EUR1.5bn-equivalent PIK toggle by Schaeffler, split into euros and dollars, which was not only the largest publicly sold PIK toggle bond in history but also achieved the lowest-ever yields.
But it does not include the AA’s GBP350m PIK toggle, which was unrated – and the largest sterling deal in the asset class.
While the equity market is improving and Europe’s economic fundamentals are beginning to recover, Moody’s warned that PIK issuers could still face dowgrades this year.
Moody’s assigned a negative outlook or downgraded the corporate family rating of six companies that issued PIK notes in 2013.
And it said new PIKs could come from less creditworthy companies in 2014.
Last year’s deals came from better-performing and deleveraging LBOs, with issuance predominantly from stable economies – Germany, the UK and Switzerland.
This year Moody’s believes “resistance to weaker issuers and terms will be tested in 2014”, driven by an intensified hunt for yield.
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PIKs are risky because of their deep subordination and low recovery rates in the event of a default, and their volumes are often seen as a barometer of broader risk appetite.
While PIK toggles have been a mainstay of the US market for a while, last year saw their emergence in Europe.
The toggles are a variation on PIK notes that pay coupons in cash if the issuer can, while leaving it the option of allowing interest to accrue on the principal if it cannot.
The bulk of PIK toggle issuance has been in the pay-if-you-can format, which requires cash payments if there is enough liquidity and capacity.
This is in contrast to pay-if-you-want clauses that allow the PIK issuer to make PIK or cash interest payments at will.
While Moody’s expects that most pay-if-you-can issuers will continue to pay cash interest if they meet forecasts, the payment of this interest will use cash that could otherwise be applied to support the creditworthiness of the issuers.
It also said there is little standardisation of terms across the sector, and that this could lead to price volatility if the toggle option is used unexpectedly.
Some investors have warned that several recent deals structured as pay-if-you-can have restrictions on payments that mean there is not enough cash to service the debt.
Spain’s Befesa, for example, priced a EUR150m PIK toggle in November, despite a EUR6m restricted payment basket covering barely more than a third of the PIK’s EUR15.75m annual coupon.
One investor said it was “stunning” the deal got done. (Reporting by Robert Smith)