Fitch Ratings • LTM European Holdco PIKs – the next stage of the bull market

The 2007 guide to Leveraged finance

Evolution to Date While smaller PIK instruments subscribed by private equity houses and some mezzanine funds have long been an element in aggressive leveraged financings in Europe, the more recent phenomenon of dividend-oriented, widely-syndicated Holdco PIK issuance in Europe became popular in late 2004, around the same time as European second lien began to enter the mainstream. Since then Holdco PIK issuance in Europe has evolved and matured, extending now to both fixed and floating-rate instruments in loan or note form. Furthermore, Holdco PIK is no longer used simply to make distributions to shareholders, but also for acquisitions, LBOs and refinancing of other junior instruments. The instrument, in all its various forms, is a popular, if opportunistic, financing choice among arrangers and sponsors, notwithstanding reliance upon potentially more volatile hedge fund investors as opposed to the traditional bank, CLO, mezzanine or high-yield investor bases.

Amid continued growth in liquidity and demand for leveraged credit products among all dedicated credit investor groups, the market has witnessed strong growth in Holdco PIK issuance over the past 12 months, and the last two quarters in particular. Although issuance levels have been more volatile than those for second lien, for example, the flood of Holdco PIK issuance in the last two quarters in particular has driven LTM volumes of European Holdco PIK to equal and even overtake those of European second lien instruments, reaching €9.4 billion at Q107 compared with €9.3 billion for second lien.¹ The largest Holdco PIK deal so far seen in Europe was the €1,670 million equivalent issuance for Wind in Q406, an amount which dwarfs the largest European second lien instrument (€700 million for Wind again) and the largest European mezzanine loan (€1 billion for Casema) to date.

The recent upswing in popularity of the Holdco PIK instrument represents the latest testament to a current buoyant leveraged market environment: favourable economic conditions and extended, historically low default rates, combined with excess liquidity arising from low long-term real interest rates, have encouraged investors to migrate down the credit spectrum in search of yield, testing structure, pricing and leverage along the way.

Opportunistic value today... While a company is performing well, Holdco PIK instruments can offer a very attractive return, particularly if investors believe they have good visibility to a takeout or refinancing. However, the volatility of quarterly issuance volumes speaks to the opportunistic nature of this instrument and in Fitch’s view its popularity now, at the high point in the credit cycle, could quickly wane when default rates eventually rise. Their deeply subordinated position in the capital structure means that Holdco PIK investors bear the greatest amount of risk for any given credit.

...but likely accelerated loss of value in distress

Current low default rates and a benign economic environment have therefore served to maintain and even increase the popularity of these instruments, however in a distress or default scenario their value is likely to deteriorate at an accelerated pace. With no maintenance financial covenants, no security or guarantees from any operating companies, and with no cash interest payable and a longer tenor than all other debt, it is virtually impossible for these instruments to default unless the Restricted Group defaults on its debt, at which point the ability of the Holdco PIK investors to exert any influence on the recovery proceedings is minimal and may even be more limited than equity holders, who will have a seat at the negotiating table and can more actively demand concessions.

Although recent increases in leverage throughout the European leveraged credit market have depressed anticipated recoveries for junior debt, mezzanine and second lien instruments still have second or third-ranking access to the security package, and although their rights may be somewhat restricted, they still have an opportunity to influence the process to a limited degree. If equitized, this will likely be done at a level closer to the operations than the Holdco PIK investors. In order to preserve value and stop any leakage to Holdco PIK investors, Restricted Group lenders can, if necessary, enforce on share pledges held at the Restricted Group level, effectively orphaning the Holdco PIK issuer and leaving investors with nothing. Distressed investors in the secondary market looking to buy into junior instruments and influence workout proceedings will therefore likely find no value in the Holdco PIK instrument, and holders will be unlikely to be able to minimize losses through a trading strategy.

Holdco PIK: The new substitution risk?

In a reflection of a trend already evident in the second lien market, the explosion in popularity of European Holdco PIK and its competitive pricing and high-yield-style incurrence covenants have led to its use as a substitute for traditional junior-secured mezzanine financing. In many ways, this product substitution may be a reflection of investor base substitution, as hedge funds (the dominant investors in Holdco PIK) demonstrate greater flexibility and risk appetite to meet sponsors’ increasingly demanding terms. Mezzanine substitution by PIK has produced a counter-intuitive disparity in pricing: despite its deeper subordination and lack of security, Holdco PIK is often less expensive than mezzanine in margin terms, as evidenced in Chart 2.

Opportunistic investor base Thus far, investors appear to be largely hedge funds, as traditional long-only investors such as CDOs and mezzanine funds have cash interest liabilities which make it difficult to work with instruments that have no cash-pay element at all, and therefore do not cover the cost of funds. This limits their ability to invest in PIK instruments, unless they can be packaged with other cash-pay debt instruments to generate the required cash income. That said, some CLOs are increasing the size of their junior debt "baskets" in order to boost overall equity returns, particularly given the current environment of declining cash instrument spreads. Hedge funds have far fewer limitations and therefore appear to make up the majority of the Holdco PIK investor base at this stage. Other investors include High-Yield investors and Private Equity houses, in search of yield and increasingly willing to take on greater levels of risk.

The introduction of an intermediate instrument, perhaps mezzanine with cash-pay EURIBOR and an all-PIK margin, may yet open up a wider investor base, although this instrument would not constitute Holdco PIK as described in this article.

Fitch’s Ratings Treatment

Notwithstanding the increase in total leverage which Holdco PIK instruments allow and the apparent increase in aggressive structuring, the agency does not necessarily consider additional Holdco PIK debt as detrimental to a borrower’s Issuer Default Rating (IDR), provided certain conditions on credit support, maturity, and enforcement rights with regard to the rest of the restricted and rated borrower group are satisfied. Although each issue is examined on a case-by-case basis, broadly speaking if the Holdco PIK instrument is:

• PIK for life (or if cash-pay at the issuer’s option, restrictions on dividends at the Restricted Borrowing Group exist that would make this impractical)

• Issued by a Holdco outside the restricted borrowing group;

• Unsecured and unguaranteed;

then issuance of a Holdco PIK instrument would not be expected to impact an issuer’s IDR.

Indeed, additional Holdco PIK debt, which is used to prepay subordinated debt within the Restricted Borrower Group may even be viewed as a de-leveraging event which enhances financial flexibility, by virtue of the lower amount of cash-pay interest falling due. To date, however, such mezzanine substitutions have been accompanied by complementary increases in senior leverage, mitigating any de-leveraging effect from the Holdco PIK issuance, although still reducing the forecast cash interest payments and therefore somewhat enhancing financial flexibility.

¹ The data in this article is compiled from a combination of public and private information sources.