The past year has seen the fastest ramp-up in interest rates since the 1980s, with rates pushed to their highest absolute level since the global financial crisis. For borrowers of floating-rate debt, this has meant a dramatic increase in the cost of debt service; for borrowers of unitranche debt their overall interest burden may have increased by 40 percent or more.
In highly leveraged capital structures, this has put very considerable pressure on cashflows and, in some instances, raised the prospect of potential liquidity issues. Similarly, in the case of new primary acquisition financings, stubbornly high valuation multiples are creating structuring headaches for private equity sponsors, who need to bridge the gap between the high prices demanded by vendors and the debt burden that the company in question can tolerate.
One feature of the private credit market that has historically distinguished it from the liquid credit market is its willingness to contemplate that some of the interest accruing on loans provided may be “paid in kind” (known as PIK interest) by being capitalised and added to the principal amount outstanding, rather than paid in cash. While on specific transactions, some or all the interest may at all times be paid in kind (particularly if it is structurally junior debt), the most common formulation seen in senior private credit financings is a PIK toggle, which is a borrower option to pay a certain amount of interest in kind as and when the need arises.
First and foremost, lenders will look to ensure that the borrower in question is an eligible candidate for a PIK toggle from a structural perspective. If it looks like the PIK feature is being used to fund an unjustifiably high purchase price (by facilitating a higher level of leverage than the company can feasibly service) then that will not likely be palatable to a lender.
However, if it is within a sector that generally attracts high valuation multiples and the sponsor is putting in a meaningful equity cheque, that is likely to be received much more favourably. Lenders will generally be more open to allowing a PIK toggle where there is an accretive buy-and-build strategy, as this may necessitate temporary periods of elevated leverage and reduced cash cover following debt-funded acquisitions (before synergies are realised), when a toggle may be a useful feature.
Allowing interest to be paid in kind constitutes an increased credit risk for a lender, as it is essentially allowing a cash revenue stream to be deferred until a later date. As a result, a lender will expect to receive additional compensation for allowing interest to be capitalised. This is achieved in two ways.
The first is inherent to the way in which PIK interest is paid. When it capitalises, it is added to the principal amount of the loan that is ultimately payable at maturity. From the point it capitalises, it therefore accrues interest – this is an “interest on interest” effect, which represents an increase in overall return for the lender.
The second is a negotiated term, which is any premium applicable to the pricing of the loan when the PIK toggle is exercised. Some large sponsors will look to replicate the formulation commonly seen in the world of high-yield PIK notes, being a flat premium payable on top of the rate that would be payable if the interest were paid in cash. However, this remains relatively uncommon within private credit, where the approach is generally that the premium will be calculated by reference to the amount of margin capitalised (and will scale up proportionately).
It is common for private credit lenders to limit the amount of margin that may be capitalised (and/or to include a “minimum cash interest” concept). This is important to give comfort that the toggle cannot be used to avoid a payment default in a material liquidity crunch. Requiring that there is still a meaningful cash-pay component ensures that, if the company has really run out of cash, it will still miss its cash interest payment and the lenders will have an actionable default and a seat at the negotiating table.
Lenders, particularly in the mid-market, will often look to ensure that PIK toggles are being used to address temporary periods when cashflows are tight, rather than representing a permanent feature of the debt service profile. As a consequence, they may look to limit the aggregate length of the interest periods in respect of which the PIK toggle may be exercised. On more conservative deals, lenders may require that the toggle cannot be exercised in consecutive interest periods, for the same reason.
Lenders will also generally look to ensure that the PIK toggle has “ordinary course” flexibility, rather than an option that can be exercised when there are already signs of material distress within the business. As a result, lenders commonly request that the company’s ability to use the PIK toggle is switched off if there is a continuing event of default (or material event of default).
Lenders may restrict usage of the PIK toggle to circumstances in which cash is tight following transformational debt-funded M&A activity. For example, they may require that the PIK toggle only be used in the first 12 months after closing or within the 12 months following any material bolt-on acquisition funded with the delayed-draw facility. Sponsors on larger deals will generally be resistant to this restriction.
Some lenders in the mid-market will take the view that, for so long as they are foregoing receiving certain cash interest payments, there should be no distributions of cash out of the banking group by way of distributions to equity. As a result, they may require that the PIK toggle may not be exercised if a permitted payment to the sponsor has been made during that interest period.
For structural reasons, collateralised loan obligations are generally unwilling to accept PIK toggles within loan documents and, as such, PIK toggles have not become a feature of the syndicated loan market. Consequently, PIK optionality has become yet another area in which private credit has a competitive advantage in offering sponsors and businesses more tailored operational flexibility when managing their cashflows.
Lenders will surely be interested in developments in this area from a defensive standpoint (to ensure that any such features cannot be abused in a rising rate environment), while also acknowledging that such technology will continue to be of genuine and justifiable value to sponsors that are pursuing ambitious M&A strategies and managing complex processes of corporate integration. The incremental return lenders can generate when interest is capitalised is also clearly of value, when such toggles are structured, priced and documented correctly.
Daniel Hendon is a partner and Phil Anscombe an associate in the private credit group of law firm Proskauer Rose