It's A PIK Toggle Credit Bubble, But "This Time It's Different" Says Moody's
Two weeks ago we first pointed out that as a result of the quiet creep in high grade leverage to fresh record high levels, the resurgence in PIK Toggle debt for LBOs and otherwise, means that the credit bubble is now worse than ever and that the next credit crisis will make 2007 seem like one big joke. Recall that nearly 80% of PIK issuers made a PIK election during the last downturn, "paying" by incurring even more debt and in the process resulting in huge impairments to those yield chasing "investors" who knew they were going to lose money but had no choice - after all, the "career risk." Subsequently, we quantified the explosion in covenant-lite loans - another indicator of a peak credit bubble market - as nearly double when compared to the last credit bubble of 2007 (whose aftermath the Fed, with a $3 trillion larger balance sheet, is still struggling to contain).
So now that the cat is out of the bag, it is time for those legacy Monday-morning defenders of credit bubbles of all kinds, the rating agencies, and particularly Moody's, to come to the defense of a system flooded with excess debt and liquidity, and state, with all seriousness, that this time the PIK Toggle bubble "is different." No really: even the title of the report by Lenny Ajzenman (which we have saved until such time as to remind how catastrophically stupid the rating agency were, are and always will be if only in matters not involving leaks of LBOs to well-paying friends of the agency) is a work of art :"Aggressively structured PIK toggle bonds are back, but they differ from bubble-era deals."
We could stop there, but since it is Moody's, let the humiliation ensue.
Here is what the report says:
PIK is back, but it’s not the same [ZH translation: "It's different this time"]
The reappearance of bond issues with PIK features has some market observers drawing parallels with the credit bubble, when PIK instruments figured prominently in financing some of the largest LBOs of the day. PIKs have been associated with high risk ever since, but the new crop of PIKs differs in a number of respects from the bubble-era vintage. One thing has not changed, however: Today’s PIK issuers are just as leveraged as their bubble-era predecessors, so these deals still present significant risk to investors.
PIK issuance virtually disappeared in the aftermath of the credit crisis, but it has come back in the past few years. Rated US non-financial companies have issued 13 PIK bonds totaling $5.1 billion this year through 31 August, compared with 14 totaling $5.8 billion in all of 20121 (see Appendix for the complete list). PIK issuance rebounded in July as markets recovered from the pullback prompted by concerns the US Federal Reserve would soon taper its bond purchases. Investors have been drawn to these bonds because they have higher yields than traditional cash-pay bonds. More deals are likely this year.
PIKs, which allow a company to pay interest with more debt rather than cash, in the past two years generally have been used to fund dividend payouts to private equity sponsors or for share repurchases. They have been used only occasionally for LBOs and acquisitions. During 2006-07, however, PIKs were predominantly used to fund LBOs, including some of the massive, top-of-the-market LBOs that came to characterize the era. A number of these large LBOs, such as the $44 billion acquisition of Energy Future Holdings or the $27 billion buyout of Harrah’s (now Caesars Entertainment Corp.), performed weakly during the subsequent economic and financial market downturn and many continue to struggle.
Ok. Let's stop here. According to Moody's, this time "PIK Toggles" are different because, wait for it, while total leverage is now higher than it ever was as we showed before and below...
... the use of proceeds is for noble causes such as dividend recaps and stock buybacks.
The only problem with this is that this (absolute non) logic presupposes that debt that is used to fund dividend distributions for shareholders and increase EPS is somehow better than debt used to fund LBOs, or any other all time record high debt for that matter. Not surprisingly, this is just the issue we discussed almost a year ago in "Where The Levered Corporate "Cash On The Sidelines" Is Truly Going" in which we showed that a surge in buybacks is simply a lagging indicator to an overall market bubble, and that contrary to Moody's amateur observations, soaring debt for whatever purposes (and especially if not used to fund growth) is always a precursor to an overall crash:
The fact that Moody's even mentions this argument is greater grounds for stripping them of their NRSRO status than any evil, evil downgrade of the US the objective Egan-Jones could have performed.
But since that is purely a pipe-dream, here are the other pearls of Moody's wisdom:
The current crop of PIKs also differs from the bubble era deals in that it is coming to market at a different point in the private equity holding cycle. During 2006-07, sponsors often used PIK debt in the financing packages of LBOs that represented the start of the private equity firm’s holding period; now, several years later, PIK issuers often occupy the more seasoned portion of private equity portfolios. More than half of the sponsor-backed PIK issuers in 2013 are companies that sponsors took control of in 2010 or earlier.
So while in 2007 PIK Toggles were used as the missing funding piece in a company's LBO, now it is the same PIK Toggles' turn to fund the dividend exits of the same LBO sponsors who are unable to sell the companies for the traditional 20% IRR so instead companies are getting even more incremental leverage. To wit:
Private equity firms may now be positioning for exits from these investments. Some are issuing PIK debt to help fund dividend recapitalizations and show investors a return, while preserving the option of an initial public offering or sale in the near future. CommScope Holding Company Inc. (B2 stable), for example, filed for an IPO less than a year after issuing a PIK bond to fund a dividend recap.
There is some good news: while covenant lite loans may be at all time highs, PIK Toggles have yet to catch up. This is, according to Moody's, good news.
While the PIK toggle bond is clearly back in the market, the dollar amount of issuance still trails bubble-era levels by a wide margin. To put the current level of PIK issuance in perspective, in November 2008 we published a list of 63 outstanding rated PIK toggle instruments issued primarily in 2006-08 with a total face value of more than $34 billion – more than triple the PIK issuance since the beginning of 20124. The largest PIK issuance so far in 2013 has been the $800 million issuance by Michaels FinCo Holdings, which was far less than the more than $4 billion of PIK debt issued in 2007 in connection with the LBO of Energy Future. During 2006-08, 12 PIK bonds were issued with face amounts of more than $1 billion.
That said, Moody's is correct that the covenant structure of the new batch of PIK Toggles is just modestly more restrictive. However, "restrictive" in the context of an overall capital structure that has never been more permissive to shareholder friendly activities - again, covenant lites are at all time highs - means very little if anything at all.
The new vintage PIKs, on the other hand, typically require a company to pay interest in cash to the extent there is restricted-payments capacity under its covenants for upstream dividends from the operating subsidiary, subject to certain conditions. This provision limits the flexibility of the company to hoard cash, make investments or repay operating company debt while allowing interest on the PIK issued at the holding company level to accrete, increasing credit risk for the PIK investor. Under the new PIKs, companies generally would be unable to pay interest with more debt until weakening operating performance eroded restricted-payments capacity under subsidiary covenants. Although most of the new vintage of PIKs have used this structure, a few deals have been completed using the “pay at will” structure including those of Envision Healthcare Corporation (B2 stable) and EPE Holdings LLC (Ba3 stable), parent of EP Energy, in 2012, and BOE Intermediate Holding Corporation (B3 stable), parent of BWAY, in 2013.
The newer PIK structures provide companies with less flexibility to manage their liquidity. In the past, use of the PIK option was often a sign of weakening credit quality, but not always. Sometimes, companies used the PIK feature because they believed capital expenditures or growth investments were a more productive use of cash than interest payments. Other times, the PIK option could conserve liquidity in an uncertain economic environment. The use of the PIK option in these newer structures will be directly tied to weakening credit quality, although the timing of any transition from cash to PIK interest will vary based on the size of the restricted-payments basket of a particular issuer. Furthermore, with the increasing prevalence of covenant-lite credit facilities, issuers could be required to pay interest in cash on PIK debt even as operating performance declines.
The use of the PIK option can also assist in covenant compliance. Some speculative-grade credit agreements carve out PIK instruments from the definition of covenant debt, particularly those PIK instruments issued at a holding company. The exercise of the PIK option can lead to the build-up of cash balances, which can help compliance with net debt covenants, or can be used to direct cash to repay debt included in the definition of debt for the purposes of covenant compliance.
But not even Moody's would admit to being so clueless that at the big-picture level this development is anything but bad. That is indeed the case.
The new PIK deals offer investors advantages over the older vintage, but they still expose them to significant credit risk. Restrictions on PIK elections, shorter tenors, and issuers with a history of deleveraging may present less credit risk for investors, but these benefits are balanced against highly aggressive capital structures. Consequently, all of the 2013 PIK issuances have very low ratings from Moody’s.
Most of the new PIK deals have high pro forma debt/EBITDA leverage of 6x-7x or more, similar to the bubble-era deals. Of the deals completed this year through August, more than 80% had pro forma leverage of at least 6x. The PIK issuers generally have deeply speculative-grade CFRs of B2 or B3, with the PIK instruments themselves generally rated Caa1 or Caa2. The low CFRs typically incorporate very high financial leverage and aggressive financial policies, and the even lower ratings for the PIK instruments, typically issued at the holding company level, reflect their structural subordination to the debt and non-debt obligations of the operating subsidiary.
One PIK issuer with high leverage is Epicor Software Corporation (B3 stable). The Caa2 rated PIK issuance in June by EGL Midco, Inc., a holding company of Epicor, brought financial leverage through the holding company to around 8x. The high debt level and aggressive financial policies more than offset the strong vertical market position the company and its predecessors built as well as its diversity of end markets. The strong market position contributes to relatively stable maintenance revenue streams, which were only minimally affected during the recent economic downturn.
While the older PIK deals typically came to market when the US economy was growing more rapidly than it is today, many of the issuers ended up under credit stress once the credit crunch and recession took hold. Today’s PIKs are coming amid lower GDP growth and higher unemployment, but the economic outlook appears relatively stable, albeit sluggish. Recent PIK issuers likely have lower growth prospects embedded in their forecasts. We expect US GDP to rise 1.5%-2.5% in 2013 and 2.0%-3.0% in 2014.
Nevertheless, given the high leverage, structural subordination and contractual provisions that allow issuers to avoid paying cash interest at a time of credit stress, PIK bondholders are particularly vulnerable in the event of a significant economic downturn. While our central economic scenario calls for continued slow growth in the US economy, a return to recession could challenge PIK issuers’ ability to service their debts and refinance maturing bonds.
In conclusion, however, it wouldn't be Moody's if they didn't try to positive spin on everything, even if they know the end result will be far worse then what was seen even during the last credit bubble.
We do not expect the newer PIK deals to exhibit the very high default rate seen among bubble-era deals. About 32% of the companies that issued PIK bonds during the bubble era defaulted sometime from 2008 to mid-2013, and some of them are at risk of defaulting again. Most of these defaults occurred via distressed exchanges in 2009.
If the US economy continues its slow but steady recovery, we would not expect the new PIK issuers to repeat this high default rate. However, in the event of another economic downturn, the aggressive leverage in these deals would leave these companies vulnerable. Private equity firms, which sponsor many of the PIK issuers, would likely continue to use distressed exchanges to preserve equity value.
In summary: when it all cracks this time, as it always does, nobody, nobody, will have been able to see it coming as always. Certainly not those who invest other people's money in 8x leveraged HoldCo PIK Toggles.
For those curious, here is a summary of the latest PIK Toggle done in recent months:
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