Stretching Leverage: Holdco PIK Financing Instruments

Holdco payment-in-kind financing instruments (Holdco PIKs) have become increasingly prevalent both in leveraged acquisition financing structures and transactions facilitating dividend recapitalisations. This article considers the key features of these instruments, the benefits which they offer to financial sponsors as well as the risks that creditors of such instruments should be aware of in a downside scenario.

Overview

The rapid growth of the leveraged credit markets, together with the increased prominence of credit funds eager to deploy capital, has caused both financial sponsors and their credit providers to seek out new ways to stretch leverage for acquisitions and ultimately allow financial sponsors to become more competitive in auction processes. Such financial engineering has led to the evolution of a relatively niche market of deeply subordinated financial instruments known as Holdco PIKs.

Holdco PIKs offer financial sponsors the ability to raise additional capital to increase leverage, reduce the equity component of acquisition consideration and, where desirable, increase the yield available to creditors to a level greater than returns associated with senior loan financings. Traditionally, Holdco PIKs were a feature of a bullish high-yield bond market in which financial sponsors sought to pursue dividend recapitalisations financed by raising a deeply subordinated capital markets debt instrument. This instrument would have minimal or zero cash interest cost to the operating group and limited impact on the operating group's activities, but with a yield that was attractive enough to attract bond investors. However, in recent years, both alternative credit providers and commercial banks have become increasingly active proponents of this product, offering it to financial sponsors both in large-cap and middle-market transactions.

Structure

Holdco PIKs generally have the following features:

• They are fixed or floating rate instruments issued by a holding company of a corporate group such that the instrument is structurally subordinated to any senior or subordinated debt incurred by the operating group but ranks ahead of all equity contributed by the financial sponsor and co-investors (if any).
• They take the form of a loan agreement or a note instrument, depending on the desired investor base, pricing and tax considerations.
• They permit the relevant debtor to pay interest "in kind" in the form of additional debt (comprising outstanding principal, in respect of Holdco PIK loans, or additional notes, in respect of Holdco PIK notes) rather than cash. This feature allows a financial sponsor to increase group leverage, without triggering any cash-pay interest obligation on the operating group.
• Holdco PIKs will have a final maturity date beyond that of any senior debt incurred by the operating group.
• They contain covenants and events of default that substantially mirror the senior debt in its then-current form (usually without the financial covenant(s), or, if included, with additional headroom to the covenant levels for the senior debt). Further technical adjustments may be made to reflect the structurally subordinated position of the Holdco PIK within the capital structure. Holdco PIKs also often include a number of additional controls on the operating group and/or ratchets on only credit support available is through a first priority security interest over the shares of the relevant borrower/issuer. This security allows creditors to (or threaten to) appropriate the financial sponsor/co-investor's equity in the event of a default being triggered under the instrument. As such, any debt service or repayment of principal on a Holdco PIK will be contingent on distributions being made from the operating group which, in and of itself, will be subject to the terms and conditions of the senior debt, the availability of distributable reserves as well as the general desire of the shareholders to make such payments.
• Given its position in the capital structure, and the absence of any guaranteed upstream credit support from the operating group, Holdco PIKs are ordinarily not subject to any separate intercreditor arrangements or required to become subject to any intercreditor arrangements at the operating group level, the consequences of which are further discussed below.

Key Documentary Hotspots

Holdco PIK documentation, much like senior debt documentation, has predominantly been underwritten on a "covenant-lite" basis, whereby there are no financial maintenance covenants and covenants are tested on an incurrence basis only.

As the Holdco PIK instrument is customarily held by investors with divergent interests to those holding senior debt, there has been a general desire on the part of such investors to ratchet back some of the flexibility negotiated for the senior debt, certain provisions of which are discussed below.

Additional Debt Incurrence and Anti-Layering

Investors in Holdco PIKs will look to regulate both the additional amount of debt that could be raised by the borrower and any priming debt by its subsidiaries (including the operating group). This may include any combination of a financial maintenance covenant testing overall group leverage, the ratcheting back of the quantum and/or leverage ratio levels of certain debt baskets negotiated for the operating companies for the senior debt—limiting the amount of additional PIK debt or other debt that can be raised at the borrower level so as to ensure a clean single point of enforcement, and/or insisting on "anti-layering" protection limiting the amount of additional senior debt that could be incurred between the borrower and senior debt.

Cash Leakage

Holdco PIKs will typically include a number of "permitted payments" and "permitted investments" baskets, allowing the financial sponsor to return value from the operating group through distributions or otherwise. Investors will seek to regulate the amount of value leakage via the Holdco PIK borrower, which may include eliminating or reducing the quantum of the restricted payments "build-up" basket, ratcheting back the quantum and/or leverage ratio levels of "permitted payments" baskets negotiated in the senior deal (effectively requiring the operating group to de-lever) and/or also requiring the operating group to repay a portion of the Holdco PIK.

Type of Holdco PIK

Depending on investor appetite or requirements, a Holdco PIK may fall into one of four broad categories, comprising the following:

• "Traditional" PIK: whereby the interest payment structure is established upfront and is required to be paid solely "in kind" and/or with cash interest at a certain point in time.
• "Pay-if-you-can": whereby the borrower is required to pay cash interest, but under certain circumstances can pay interest in kind (e.g., where it has no distributable reserves or due to payment blocks in the senior debt financing).
• "Pay-if-you-want": whereby the borrower can, in its sole discretion, elect to pay interest in any given period in cash.
• "PIK Toggle": whereby the borrower can, in its sole discretion, elect to pay interest in any given period in cash, in kind and/or a certain percentage in cash and "in kind", depending on the amount of "cash available for debt service". In addition, the amount of cash interest which the borrower can pay "in kind" may be increased subject to a minimum cash balance being retained by the borrower group.

Salient Risks for Creditors

In pricing a Holdco PIK, creditors accept the risk that their paper may have little recovery value or that they may have a limited ability to influence the outcome of restructuring negotiations in a downside scenario.

For instance, the likelihood of a "payment default" crystallising prior to the maturity of a Holdco PIK is significantly diminished in comparison to senior debt incurred at the operating company level, given that interest payments are often capitalised throughout the life of the instrument. As such, practically speaking, events of default under a Holdco PIK are more difficult to trigger, and usually will arise in the event of a cross-default or cross-acceleration to debt incurred by the operating group (depending on the negotiated documentary position with the financial sponsor) or upon a bankruptcy/insolvency event.

Since Holdco PIKs are not usually subject to intercreditor arrangements either at the senior debt borrower level or the operating group level, the creditors, theoretically speaking, have an independent right to accelerate their primary debt claim. Also, to the extent of any security interest having been granted over the shares of the relevant borrower, they may also look to enforce on such security in a default scenario and take control over the relevant borrower, thereby stripping value away from the financial sponsor and co-investors (if any). The practical reality, however, is that the taking of any such enforcement action would trigger a "change of control" in the senior debt likely requiring repayment thereof. In addition, given the deeply subordinated position of a Holdco PIK in the capital structure as well as the lack of any direct recourse to the operating group, in a downside scenario, the equity may likely be of limited value and the creditors may well be left with minimal or zero recovery on their debt claim, particularly in a scenario where value of the operating group breaks in the senior debt.