Whilst the Bank of England base rate has stabilised somewhat to 4.00% from its most recent high of 5.25% in August 2023, the expectation is it will plateau at 3.50% in mid 2026, assuming no unexpected shocks that trigger rates to spike again. In short, the days of free money are long behind us and the expectation is they will not return any time soon.
What does this mean for Borrowers? Even for the strongest credits with high earnings visibility and best in class cash flow conversion, (cash pay) debt capacity is lower than it used to be – i.e. you cannot put as much Senior leverage on businesses as you used to be able to. For weaker credits, with less visibility on forecast earnings, less strong cash flow conversion and a historic “credit story” to get lenders comfortable with, (cash pay) debt capacity is significantly lower than it once was.
What does this mean for Sponsors on the buy side? Put bluntly, they either need to agree a lower purchase price (which as we know is often not compatible with vendor expectations); put in more equity (which can lower forecast returns); or come up with other creative solutions to preserve the old world view on debt capacity / leverage.
So what creative solutions are out there for Sponsors on the buy side? Several options exist. Starting with the most basic, Borrowers can negotiate a portion of the Senior margin to be structured as permanent PIK (payment in kind) to improve credit metrics and increase debt capacity. However, this can only be achieved on Unitranche deals (which may not always be the preferred approach) as banks typically cannot offer PIK interest. Furthermore, given debt funds’ minimum cash pay interest requirements, senior leverage will quickly cap out, albeit at a slightly higher level than on a fully cash pay margin Senior deal.
At the other end of the spectrum, Borrowers can attempt to fill the equity shortfall with a preferred equity instrument. Whilst there are some clear advantages to such an instrument (no cash pay interest, no scheduled maturity date, no financial covenant etc.) the main stumbling point for Borrowers is often the overall cost, particularly as many (less well advised) deals also include an equity upside component. Whether or not the pref equity is structured as a fixed rate instrument or includes some form of upside, they are expensive and also impact returns.
Of more interest to many sponsors looking to maximise total leverage, but achieve a competitive blended cost of capital, is a Senior debt deal (either bank or private debt arranged) with a HoldCo PIK facility on top.
What is HoldCo PIK? HoldCo PIKs are junior instruments (contractually and structurally subordinated to senior debt), non cash pay, where the Borrower is able to defer interest payments until maturity, thereby increasing the overall debt capacity of the capital structure. Holdco PIKs are provided by debt funds (either separate to the Senior debt or the same provider).
Pricing on HoldCo PIKs vary significantly depending on a variety of factors including: EV, credit quality, Senior debt attachment point, how competitive the debt process is and the perception of the Sponsors willingness to pay! Often one of the key attractions of HoldCo PIKs as opposed to other more equity like instruments, is the possibility of structuring them as fixed return instrument with no equity upside (albeit often Borrowers without advice or poor advice end up giving away some form of upside on HoldCo PIKs, e.g. warrants).
Ensuring you have the right advice when implementing a HoldCo PIK is absolutely paramount. Time and time again we have seen situations where Borrowers were not advised (or advised poorly) at the time of implementation and the structure of the HoldCo PIK was suboptimal. For example we have seen situations where the HoldCo PIK is included in the Senior Group and captured in the financial covenants and other elements of the facilities agreement where it should be passive.
The Newbrook team has deep expertise and experience in advising borrowers on HoldCo PIK instruments. Most recently, the Newbrook team advised a tier 1 sponsor on a c.£0.5bn Unitranche / PIK which differentiated their financing and gave them an edge in a competitive auction process.
Despite the focus of this article, HoldCo PIK use is not limited to new money processes. For example, Newbrook has advised on several situations where the Senior debt is over leveraged and a PIK lender has been introduced to deleverage the Senior debt and to avoid an equity injection by the sponsor.
If you would like to discuss HoldCo PIKs or financings in general please do not hesitate to reach out to one of the Newbrook team.