The leveraged buyout boom is dead. But its ghost haunts the debt markets, thanks to a financial tool that gives dozens of companies the option to skip cash interest payments on more than $33 billion worth of junk bonds used to finance some of the most high-profile deals of the era.
And hospital chain HCA is one of at least 18 companies taken private that have exercised a so-called payment-in-kind, or PIK, option on their bonds. The option allows them to make interest payments using more debt instead of cash. Standard & Poors LCD News said earlier this month that 47 companies, most controlled by private equity, have PIK bonds outstanding worth a total $33.4 billion.
Companies that have opted to exercise a PIK say it is a cost-effective method for shoring up cash in times of trouble. Critics, on the other hand, liken the practice to a card player doubling down on a losing hand. Im not a fan of PIKs, said Vicki Bryan, senior analyst at research firm Gimme Credit. Theyre actually increasing their borrowing costs and increasing their debt load at a time when theyre struggling to support the debt load they have.
One private equity player, an executive with the firm TPG Capital, said that view is shortsighted. Part of what we do here is we prepare for all scenarios. This is one of those things that you put in (a deal) because it gives you flexibility, said the executive, who asked that his name not be printed as TPG typically bars employees from speaking to the media. In the current macroeconomic environment, is there any company that wouldnt benefit from having additional cash? No.
In the frothy credit market between 2005 and 2007, TPG and other buyout giants, such as Kohlberg Kravis Roberts, Apollo Investment Management and Bain Capital, demandedand received from lendersincredibly flexible financing terms. The thinking was that in a worst-case scenario, PIK options would enable portfolio companies to maintain cash flows should sales soften, thus avoiding a default, bankruptcy or other credit event that could wipe out their equity.
Now that the theory is being put to the test, some market watchers, especially ratings agencies and high-yield bond analysts, have the jitters. They fear exercising PIK options will drive already debt-laden firms further in the hole, harming lenders and bondholders in the process by delaying the inevitable meltdown.
Executives at HCA and TXU, another PIK issuer that now goes by the name Energy Future Holdings, gave virtually identical reasons for exercising PIKs earlier this month. In regulatory filings, both noted that while they did have sufficient liquidity, it was wise to exercise their PIKs in light of the dislocation in the financial markets.
Given all the dramatic turmoil in the capital markets over the last couple of months, it is the prudent thing to do right now, said Jack Bovender Jr., chairman and chief executive officer of HCA, on a conference call with analysts. Bovender is retiring as CEO at the end of the year.
HCAs performance has been rocky since it was taken private for $33 billion in 2006 by Kohlberg Kravis Roberts, Bain Capital and the private equity arm of Merrill Lynch. The Nashville-based hospital chain posted net income of $86 million in the third quarter, down from $300 million in the year-earlier period, and it is carrying $27 billion in debt.
By skipping a cash interest payment on a $1.5 billion senior loan, the company expects to save about $145 million in cash annually. Bryan of Gimme Credit noted, however, that hoarding the cash will come at a hefty price, because the 10.375% PIK notes HCA is issuing will add about $156 million in new debt each year to the companys balance sheet.