Very PIKKY

Select issuances of payment in kind (PIK) notes in Europe signal at least a partial return of the unusual debt instrument. Orion Engineered Carbon was amongst the first to issue a PIK toggle note. The financing instrument is not suitable for every CFO, though.

Europe’s CFOs are flipping the switch again. Companies are now breathing life back into payment in kind (PIK) notes after the finanical crisis rendered this peculiar instrument useless. At the beginning of February, Orion Engineered Carbon, a carbon black producer based in Germany, was amongst the first European companies to announce it had issued PIK toggle notes in recent years.

A PIK toggle mechanism allows the issuer to choose between paying interest on the bond or deferring coupon payments, at the cost of a higher interest rate (and more accrued interest) when the notes mature. Initially planned to be USD 390 million (EUR 290m), Orion even up-sized the volume by USD 35 million to USD 425 million in total, reflecting investors’ growing risk appetite in the current low interest rate environment. PIK toggle notes have remained dormant as a financial instrument since the outbreak of the financial crisis in 2008.

The financing instrument is viewed as bearing a very high risk. Moody’s rates the Orion notes Caa1 with a negative outlook, substantially lower than the company’s B2 rating. This is because the toggle mechanism allows the issuer to switch a portion of the interest payment on the new notes to payment in kind (i.e. in higher interest rates) when they are due. According to Moody’s rating report of Orion’s notes, the PIK toggle mechanism thus “mitigates the risk of materially reducing the amount of cash at the Orion group level.” This funding structure can thus prove particularly interesting for cash-strapped companies – if they believe they can swallow even higher interest payments at maturity.

Many PIK notes issuers have a private equity past. This is true of Orion, a spin-off of German industrial company Evonik, whose private equity sponsors completed the leveraged buyout of the company 18 months ago. In August 2011, Evonik sold its carbon black business Evonik Carbon to the private equity investors Rhone Capital and Triton. According to press reports, the value of the transaction stood at EUR 900 million while Orion posted annual revenues of about EUR 1.2 billion. This makes for a less-than-impressive earnings multiple of 0.75. Investors completed what was, at the time, a typical leveraged-buyout financing, which is now being optimised through the issuance of the PIK toggle bond.

Many view the transaction as an aggressive financial policy, since it means a substantial re-leveraging of the company’s balance sheet. In typical PE-fashion, the new owner is using the notes to reduce their own preference shares and shareholder loans. In doing so, the private equity investors reduce the level of risk they face at the expense of the portfolio company.

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