PIK your partners wisely

Remember PIK? One of the (many) signs of a market bubble, with GPs basking in leverage liquidity and shunning traditional warranted mezzanine, opting instead to issue PIK notes. Despite its dangers, illustrated in this article, the instrument may be making a comeback, with cash-strapped US retailer Eddie Bauer currently issuing the note as part of an amendment fee for its $225m term loan, to defer it to 2014. If it fails to meet its covenants on time, three additional 500 bps PIK amendment fees may be issued. The allure of PIK is clear: it seems a savvy way of preserving a target's cashflow by issuing notes in lieu of interest re-payments. This not only avoids immediate cash outlay, but also constitutes payment of interest for tax purposes. A double whammy.

Or so it seemed. In fact nowadays PIK notes issued in the 2005-2008 heydey are eating away at companies and their sponsors. UK care home group Four Seasons knows this all too well. In 2006 it was bought by Qatari investment vehicle Three Delta in a £1.4bn deal. At the time, the transaction looked ideal: a Middle Eastern sovereign wealth fund awash with cash held the equity, with around £225m of mezz on top of it, and £1.24bn of senior above that, with RBS as lead lender. Nowadays the capital structure would be eye-watering - especially given that around £83m of PIK was wedged between the mezz and Three Delta. This PIK was rolling up at more than 20% interest.

It all came to a head last August when Four Seasons breached a technical covenant, only avoiding full-boar default because lenders agreed a six-month standstill agreement. The business is now valued at less than half its 2006 valuation. Creditors below the senior level feared their interest would not be sufficiently looked after during the standstill period, and so are now threatening to take over assets. Currently, Four Seasons has around £1.5bn of debt and EBITDA of just £100m. The business now has until 5 May to reach an agreement with all involved parties, with a debt-for-equity swap touted a likely outcome.

If companies in the healthcare sector - long deemed one of the most robust and least risky - are struggling, spare a thought for estate agents. BC Partners' Foxtons (another sign of a bubble about to burst at the time the deal went through) breached a covenant earlier this year. Apollo Management's Countrywide was in a similar boat, though it brought in new owners to stave off complete collapse: Apollo bought the estate agency chain in May 2007 for more than £1bn, three quarters of which was debt (and some of that pricey PIK). Last year Moody's downgraded the debt from B3 to Caa1, citing reduced cashflow and the fact that Countrywide had drawn its revolver. Just in February, Apollo brought in three distressed debt investors to co-own the business, with Alchemy, Oaktree and hedge fund Polygon joining Apollo to pump in a total of £75m additional cash. More than a third of the equity was redistributed to bondholders. The deal also saw the target's revolver repaid in full, and debt reduced to £175m.

Standard & Poor's reckons that the PIK-holders in 41 deals will recoup just 10% of the face value of their debt (four of these deals are with Apollo). It is evident that the more creative elements of a capital structure become more popular at the peak of a market, and this exuberance comes at a cost. However, recent events indicate that, rather than merely being boom time folly, products such as PIK can have surprisingly useful applications in today's difficult restructuring situations.

Slim PIKings

Despite it being heralded as a phenomenon of the recent heyday, PIK in fact traces its roots to the late 1980s, with the $25bn RJR Nabisco jumbo buyout by KKR containing $7bn of payment-in-kind securities. They were issued in 1989 and due for reset two years later. While the time-frame seemed achievable at the time the junk-bond market actually fell through the roof and the target's bonds were downgraded. Ultimately KKR pumped an additional $1.7bn into the company for its $6.9bn recap in 1991. But it was a dud: KKR ended up trading shares in RJR for Borden, which it then sold for a paltry $649m to Apollo in 2004. A few years later the Barbarians were quoted as saying: "Never issue reset notes."

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• Healthcare