Bailout funding reappears as the easy money era fades

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In April, online used-car dealer Carvana nearly abandoned a junk-bond sale it was trying 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 secure $1.6 billion of the offering.

In return, Carvana accepted more investor-friendly provisions, including replacing the issuance of new preferred stock with additional high-yield debt and accepting a stipulation that prohibits it from prepaying the new debt for about five yearsaccording to several media reports, about twice as long as the normal term for junk bonds.

The way the deal has played out is an example of how cash-constrained borrowers are finding ways to access liquidity as the relatively easy financing market that has been available to businesses for years dwindles and, as interest rates rise, soars Inflation, economic headwinds and financial market turmoil is replaced

Many companies are experiencing margin erosion due to higher input costs and supply chain disruptions. As turmoil sweeps through various sectors, many companies will remain cash-strapped, at least in the short term. These changing market dynamics are driving an increasing need for bailout financing that balances the needs of liquidity-hungry companies, sponsors and increasingly cautious lenders, according to market participants involved in structuring the recent deals.

A resurgence of PIK loans

In response to the new environment, some PE firms are renewing their appetite for alternative financing vehicles that can strengthen a company’s financial position. PIK loans, a hybrid collateral between pure debt and pure equity, are one of the bailout financing products that has seen a resurgence of late, according to Emanuel Grillo, head of Allen & Overy’s North American restructuring practice.

“What’s happening in the market is that some weak companies in various PE portfolios are under pressure and need more money, and the concern in the current market is where and how to get money,” he said. “So sponsors have to inject new funds, and they prefer to put the money in debt because it’s new dollars and there’s a reasonable risk involved.”

“You’ll see [sponsors offer] a lot of bailout funding for subordinated liens to keep their senior lenders happy,” he added.

This year, particularly in the second quarter, PIK mid-market loans have seen increasing take up by PE sponsors who injected money into financially troubled portfolio companies, Grillo said.

PIK, or Payment-in-Kind Debt, allows borrowers to defer interest payments that can be paid by issuing more securities instead of cash. By contracting such instruments, borrowers can avoid short-term immediate cash outflows and receive liquidity in times of financial distress.

PIK’s issuance is typically a symptom of buoyant valuations, for which yield-seeking investors are willing to downgrade existing debt and accept longer maturities. However, if borrowers need access to cash for working capital or other expenses in a distressed market, they can also turn to PIK instruments, which will save them from the burden of additional debt servicing, at least in the short or medium term. said Grillo.

Additionally, other types of products, such as preferred stock, can also be used as a rescue financing tool, said Gregory Bauer, leveraged finance attorney at Ropes & Grey.

“Sponsors tend to bring in preferred stock or PIK HoldCo bonds as additional capital in the bailout situation because they don’t need to go through discussions with other lenders and add capital in a way that is not constrained by the senior credit facility that is already in the capital stack,” said farmer.

Such deals gained prominence during the peak of the pandemic, as PE firms stepped in to provide liquidity to distressed private and public companies by offering rescue financing tools. In 2020, Roark Capital threw the Cheesecake Factory a lifeline with a $200 million preferred stock investment that offered a 9.5% dividend in kind.

And in April 2020, Providence Equity Partners and Ares Management purchased $400 million of Outfront Media convertible preferred stock. In another case, Great Hill Partners and Charlesbank Capital Partners bought the $535 million convertible debentures issued by online furniture retailer Wayfair, which paid interest in kind.

A careful look

However, some of this bailout funding could prove to be a financial drain by burdening companies with more debt.

In 2014, TPG provided financially troubled yogurt maker Chobani with a $750 million second lien bailout at 5% cash interest and 8% in kind. The debt package also offers TPG warrants that can be converted into equity. Since then, Chobani has attempted a series of refinancings to extricate itself from the costly arrangement, eventually doing so by onboarding a new investor, the Healthcare of Ontario Pension Plan, according to media reports.

S&P credit analysts are forecasting a slight increase in the number of defaulting corporate borrowers in the coming months. Default rates at higher-risk companies could reach 3% in the 12 months to March 2023, compared to the 1.4% default rate by March 2022, the rating agency said.

Banks and some private credit investors have already begun to view deals more cautiously when assessing how financial uncertainty is likely to affect their borrowers’ creditworthiness. With a tight credit market and a weakened SPAC market, some struggling companies are having greater difficulty accessing cheap financing.

“There is still plenty of liquidity in the market to deploy; however, circumstances have changed such that borrowers are now in different positions where they do not have the flexibility to negotiate more favorable terms and something more meaningful to them because they are being squeezed for cash in a way they have not been in years more,” said James Van Horn, attorney at Barnes & Thornburg, specializing in restructuring and bankruptcy.

Featured image by Mike Riley/Getty Images

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