Rescue financing reemerges as era of easy money fades
In April, online used-car retailer Carvana nearly canceled a junk bond sale, in which it sought to raise $3.275 billion to fund an acquisition, as investment bankers struggled to find enough buyers for the deal. Then Apollo Global Management, already an investor in the company, stepped in and agreed to back $1.6 billion of the offering.
In exchange, Carvana agreed to more investor-friendly terms, including replacing the issuance of new preferred stock with additional high-yield debt and agreeing to a term that prohibits it from prepaying the new debt for about five years.—about twice the normal period for junk bonds, according to several media outlets.
The way the deal has unfolded is an example of how cash-strapped borrowers are finding ways to access liquidity as the relatively easy funding market that was available to businesses for years s fades and is replaced by rising rates, rising inflation, economic headwinds and financial market turmoil.
Many companies are experiencing margin erosion due to rising input costs and supply chain disruptions. As turmoil sweeps across different sectors, many companies will remain cash-strapped, at least in the short term. These changing market dynamics are creating a growing need for bailout funding that balances the demands of cash-seeking companies with increasingly cautious sponsors and lenders, according to market participants who have been involved in structuring recent transactions.
An upsurge in PIK loans
In response to the new environment, some private equity firms are renewing their appetite for alternative financing tools that can bolster a company’s financial position. PIK loans, a hybrid security between pure debt and pure equity, are one of the bailout financing products that have enjoyed a resurgence recently, according to Emanuel Grillo, who leads the North American restructuring practice at Allen & Overy.
“What’s happening in the market is that some weak companies in various private equity portfolios are under stress and need more cash, and the concern is in the current market, where and how they are getting cash,” he said. “So the sponsors have to put new money forward, and they prefer to put the money in debt because it’s new dollars and there’s quite a bit of risk associated with it.”
“You’ll see [sponsors offer] a lot of junior lien bailout funding to satisfy their senior lenders,” he added.
There has been increased use of PIK loans in the middle market this year, particularly in the second quarter, by PE sponsors pumping money into cash-strapped portfolio companies, Grillo said.
PIK, or payment-in-kind debt, allows borrowers to defer interest payments, which can be paid through the issuance of multiple securities rather than cash. By accepting such instruments, borrowers can avoid triggering immediate short-term cash outflows and preserve liquidity during times of financial stress.
The issuance of PIK is usually a symptom of frothy valuations, for which yield-hungry investors are willing to be subordinated to existing debt and accept longer maturities. However, in a distressed market, when borrowers need access to cash for working capital or to cover other expenses, they can also resort to PIK instruments, which relieve them of the burden of a additional debt service, at least in the short to medium term, says Grillon.
In addition, other types of products such as preferred stocks can also be used as a bailout financing tool, said Gregory Bauer, leveraged finance lawyer at Ropes & Gray.
“Sponsors tend to bring in preferred stock or PIK HoldCo notes as additional capital in the bailout situation because they are not required to discuss with other lenders and add capital in a way that will not be not limited by the senior credit facility, it’s already in the capital stack,” Bauer said.
These deals gained traction during the height of the pandemic, when private equity firms stepped in to provide liquidity to struggling private and public companies by offering bailout financing tools. In 2020, Roark Capital threw Cheesecake Factory a lifeline, in a $200 million preferred stock investment, which offered a 9.5% in-kind dividend.
And in April 2020, Providence Equity Partners and Ares Management purchased $400 million worth of convertible preferred stock from Outfront Media. In another case, Great Hill Partners and Charlesbank Capital Partners purchased $535 million convertible senior notes issued by online furniture retailer Wayfair, which paid interest in kind.
A cautious view
However, by further indebting companies, some of these rescue financing operations could prove to be a financial burden.
In 2014, TPG provided financially troubled yogurt maker Chobani with a rescue loan, in the form of a $750 million second lien term loan at 5% cash interest and 8% cash payment. nature. The debt package also offers TPG warrants that can be converted into shares. Since then, Chobani has attempted a number of refinances to get out of the costly arrangement and finally did so by bringing in a new investor, the Healthcare of Ontario Pension Plan, according to media reports.
S&P credit analysts predict a slight increase in the number of corporate borrowers defaulting on their obligations in the coming months. Default rates among high-risk companies could reach 3% for the 12 months ending in March 2023, compared to a default rate of 1.4% until March 2022, according to the rating agency.
Banks and some private credit investors have already begun to take a more cautious view of entering into transactions, as they assess the extent to which financial uncertainty is likely to affect credit on the creditworthiness of their borrowers. With a tightening credit market and a weakened SPAC market, some struggling businesses are finding it more difficult to access cheap financing options.
“There is still plenty of liquidity to be deployed in the market; however, circumstances have changed in that borrowers are now in different positions, where they do not have the flexibility to negotiate more favorable terms and whatever thing that makes more sense to them, because they’re strapped for cash like they haven’t been in years,” said James Van Horn, a Barnes & Thornburg attorney and restructuring specialist and of insolvency.
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