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Old 6th August 2008, 13:52   #1
TanyaT
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Default Glazer's PIKS: Risky debt notes could be a losing game

Credit crisis one year on: Risky debt notes could be a losing game
Helen Power
Telegraph Business 06/08/2008


Notes are ticking timebombs for some of the firms that issued them and most hedge funds that bought them

Until Malcolm Glazer launched his bid for Manchester United in 2004, most readers of the financial pages would have presumed a PIK was a misspelling of something one might find down a mine.


A street vendor selling protest flags and shirts by Old Trafford Stadium
Some Manchester United fans objected to the club's new owners


Mr Glazer's bid for the football club made PIK - Payment in Kind - debt notes if not a household phrase, a more recognisable one.

His move to buy Manchester United, which saw three US hedge funds back Mr Glazer's bid with PIK note funding, was heavily criticised for overburdening the company with debt. Then everyone forgot about PIKs.

But as the UK plunged headlong into buyout frenzy in mid-2005, the use of PIK notes in UK private equity deals proliferated.

When the credit crisis hit last year, it became apparent PIK notes were ticking timebombs for some of the companies that issued them and most of the hedge funds that bought them.

In essence, PIK notes are debt on which lenders are not entitled to get regular interest payments until a company is sold or refinanced. Interest instead rolls up annually, often at exponential rates.

Manchester United is currently rolling up interest of 14.25pc on 135m of PIK notes after a planned re-financing that would have paid them off had to be pulled when the credit crisis hit last summer.

Four Seasons, the nursing home chain owned by Qatar's sovereign wealth fund, is rolling up interest at an incredible 23pc on a 165m PIK note, interest it may never be able to pay off if it fails to secure a rescue 1.5bn refinancing this autumn.

An American import, PIKs have been used by private equity for many years, but between 2005 and 2007, they mutated into a particularly risky form of debt.
"What is more recent is the use of public PIKs where a company already had publicly traded high yield debt. Then the sponsor would issue a PIK offering on top of that, which would also be held by high yield-type investors," says NM Rothschild's European co-head of debt advisory Tom Smyth.

"That was more of a bull market phenomenon where a sponsor would use it as a way to get a partial exit through a recapitalisation, with a view to refinancing later."

The founding partner of Alchemy, Jon Moulton, whose fund is now targeting distressed debt opportunities, believes PIKs could be a millstone around the necks of companies that are stuck with them.

"PIK notes were largely issued to help investors get to buyout multiples other people couldn't match, so the majority were in overpriced deals where other forms of debt weren't available," says Mr Moulton.

"PIK holders have a right to stop debt being put underneath them and they are something of a dead hand on companies. They make the equity disappear at an escalating rate and they demotivate management so it's difficult to get them to do anything."

Maria Semenko, a director in Lazard's restructuring team also believes the existence of PIKs can make it even harder to refinance a company at a time when the debt markets are still only operating with a fraction of the liquidity they had this time last year.

"The main problem is that PIKs are usually quite expensive and low down in the capital structure. The fundamental issue is the ability of a company to refinance and the fact there is a PIK in the capital structure could in turn make it even more difficult," says Ms Semenko.

A number of other private equity backed companies with PIKs, including struggling retailer Peacocks, which is owned by US hedge fund Och-Ziff, are also thought to be finding their refinancings difficult.

But some advisors argue PIKs are not all bad for all companies. They say it's all about how recently the PIKs were issued and how desperately a company needs to refinance.

"Yes, there's a bullet payment. Yes you have deferred the interest, but that can actually reduce the chance of a breach for some of these highly-geared companies. There are some companies that will actually be saved by their PIKs," argues one UK head of investment banking.

Foxtons, the estate agency bought out by private equity house BC Partners just before the credit crisis hit last year has an option to roll up the 14pc annual interest payment on 70m of its debt; in debt bankers' jargon this is called a PIK toggle.

With housing sales in freefall, Foxtons is facing turbulent economic times and rolling up interest could help it in the short term, although it is not a long-term solution. The estate agency's rival Countrywide exercised a similar option in June to start rolling up its interest payments. Whether this will save either from the worst property downturn for decades is another matter.

But whilst there may be winners and losers amongst the companies, the hedge funds and other investors who bought into PIK issues before the credit crisis will almost inevitably be on the losing side.

A recent survey by credit ratings agency Standard & Poor's expects an average recovery of just 10pc of face value for owners of 41 so-called PIK-toggle debt issues it sampled.

"To the extent PIKs are traded, they are being sold on at prices in the single digits," says Mr Moulton.

"Even on those PIKs which aren't due very soon there's a problem, because falling sale values for companies have completely eroded the equity. Investors in the PIKs will therefore be out of the money," says one senior City lawyer.

Advisers say PIK debt is widely held by financial institutions.

"The private equity houses or their limited partners will also have invested in that paper as part of their equity investments. PIKs have quite a disparate group of owners," says Mr Smyth.

But Mr Moulton says it is hedge funds and their own investors who are really sitting on a timebomb because many hedge funds do not mark PIKs to market, an accounting treatment which would slash their value if applied.

"A lot of hedge funds still record PIKs at cost plus accrued interest when actually the equity in them is completely worthless. And they are charging performance fees against these supposed profits," says Mr Moulton.

Which will leave investors facing a very nasty surprise when hedge funds finally tot up their losses.

http://www.telegraph.co.uk/money/mai...ccrisis106.xml
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