The issuance of holdco pay-in-kind (PIK) notes in Europe's leveraged finance market, for purposes other than shareholder payouts, has been increasing rapidly. While most market participants believe this growth is just another expression of unbridled European enthusiasm, they also expect PIK issuance - to fund LBOs and refinance junior debt instruments - to continue at a fast rate in the medium- to-long-term, thereby drawing interest from a broader range of investors.
The appetite for PIK notes is strong because of the higher yield they offer, although the bulk of the investor base for these instruments is still made up of the more recent buyers of European leveraged assets, namely hedge funds, that view PIKs as a bridge to an exit strategy such as an IPO or a refinancing. Along with high-yield investors, some private equity houses have also been buying PIKs, and now there are signs that collateralized debt obligations (CDOs) are increasing the size of their junior debt baskets in order to boost their overall returns, and possibly invest in PIKs in the process, said Michelle De Angelis, senior director in Fitch Ratings' London-based leveraged finance team.
In a tight spread environment, many investors are doing whatever they can to get yield, including looking at PIKs, said a source at a European CDO manager.
"The market is accepting debt/Ebitda multiples up to 9x, based on valuation multiples that have been inflated by availability of debt," he said. "At these leverage levels, most companies could not service their interest, so PIK debt is used."
However, most CDOs typically have a 5% bucket for PIKs, the source said, and this is rarely used, since including these kinds of instruments in a CDO makes it harder to cover the cost of funds for cash flow CDOs that have cash-pay liabilities. Yet the market for PIKs is undeniably growing, he said, and with second-lien debt in Europe pricing closer than ever to senior debt, and overall returns steadily decreasing, many investors are left with little choice but to consider new ways in which to manage assets in order to generate returns.
Undoubtedly, CDO managers are facing pressure from investors to generate returns on equity, even if, when compared with other financial market assets, these returns may still be higher.
The fact is that spreads are contracting in the leveraged market, so investors are getting perhaps 25 to 50 basis points less for senior debt than they did a few years ago, De Angelis said. It is therefore harder for CDOs to make the required returns on senior debt alone, so they need to consider other subordinated debt instruments.
It's unlikely that the traditional holdco PIK notes would be taken up on a widespread basis by CDOs and CLOs because of their deeply subordinated nature and the fact that in the event of a default, PIK notes offer no rights at all to investors. However, if the instrument were to more closely resemble junior mezzanine debt, there is a greater chance it could figure in CDO structures, De Angelis said. It is quite likely that the lines between cash pay mezzanine and holdco PIKs will become increasingly blurred, resulting in a sort of a "hybrid" instrument that would appeal to a more traditional investor base because it would have mezzanine elements, yet offer the flexibility of PIKs.
"We may well see the evolution of a mezzanine-like instrument with cash-pay Euribor and an all-PIK margin, which would cover the cost of funds for CDOs," she said. "The introduction of an intermediate instrument like this one would broaden the investor base, but evidently it wouldn't fit the current definition of a holdco PIK that would result in the instrument being considered quasi-
equity by Fitch."
It remains to be seen how and whether this dynamic will actually play out, but in a market where investors say that very little cash-pay mezzanine is available, and where most CDO managers feel that PIKs, as they now stand, are best left to investors like hedge funds, some kind of hybrid instrument may well be welcome.
For now, PIK issuance continues to increase. In an environment in which economic fundamentals are still good and no corporate defaults appear to be on the horizon, many investors are prepared to go further down the credit spectrum, testing structure, pricing and leverage along the way. Even though PIK instruments are opportunistic, meaning that their volumes can be rather volatile, the issuance of PIK in Europe was equal to or surpassed that of second-lien loans in the fourth quarter of 2006 and first quarter of 2007, according to Fitch, although it must be taken into account that the largest PIK deal thus far, a 1.7 billion ($2.3 billion) issue for Wind Telecommunications in 2006, makes up much of the PIK issuance volume recorded by the agency.
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