Wednesday, June 27, 2007

Payment in Kind

When a borrower has the option to make interest payment using things other than cash, it's termed "payment in kind" (PIK). The interest is then added to the principal. It's a way for the borrower to deter cash payment. Lenders do not like PIK because not only they cannot predict getting their regular interest income, but they risk losing the principal because they cannot force the borrower into bankruptcy and take over the remaining assets at the first sign of trouble. That's why PIK is rare used in loan offerings.

Not so in recent bond offerings by private equity firms. In a leveraged buyout, private equity firms borrows money from banks, which often resell the loan as a junk bond to investors to buy a business. Cash flows from the business is then used for interest payments. LBO works as long as investors are willing to buy these junk bonds and businesses generate sufficient cash flows. When putting in a PIK option in the bond offering, it basically says:" Well, we might not able to have the cash down the road for interest payment, so let us decide when to pay you and when not to."

Would any investor in his right mind accept such condition? In a red hot buyout frenzy, anything is possible. Private equity deal makers, the smartest guys in the room, smell the cyclical downturn on the horizon and promptly put in PIK in their bond offerings. In addition, if the long-term interest rate rises, businesses would have to pay more cash on interest at a time they might be short in cash. PIK saves the day. But some investors still took the plunge, all in the name of seeking a tiny bit of extra yield, disregarding the outsized risk they take on. The party is on its full blast ... until the long-term interest rate shot up. The yield on 10-year Treasury notes have been testing the 5.25% level, the current Fed fund rate, several times over the past weeks. It usually takes a while for the market to embrace a new reality, but it happens it will be rather volatile and unpleasant. My own reckoning is that it could reach 6% before the year end, and for some that spells big pain.

We are seeing some early sign that investors are waking up to the reality. Wall Street banks had to withdraw the bond offering by US Foodservice, the company bought by the private equity heavy-hitter KKR. Among other bond terms, investors are now particularly discontented about the "payment in kind" option. The failed bond offering left the Wall Street banks, such as Deutsche Bank, Citigroup, J.P. Morgan, and Morgan Stanley, who provided the bridge loan to KKR, holding the bag: $3.6 billion. That might be small changes for these big banks, but could be a significant turning point of the current LBO boom, if history is any guide. The bank First Boston went down in the 80's LBO craze when it failed to sell junk bond for Ohio Mattress and was left holding the bridge loan itself. It was forced to be sold to Credit Suisse.

That's not a very kind payment.

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