In exchange, Carvana accepted more investor-friendly provisions, including replacing the issuance of new preferred shares with additional high-yielding debt and accepting a term that prohibits it from prepaying the new debt for about five years—roughly twice the normal period for junk bonds, according to several media reports.
The way the deal unfolded is an example of how cash-constrained borrowers are finding ways to access liquidity as the relatively easy financing market that was available for companies for years fades and is replaced by rising rates, climbing inflation, economic headwinds and financial market turmoil
Many companies are experiencing margin erosion due to higher input costs and supply-chain disruptions. As turbulence sweeps through different sectors, many companies will remain cash-constrained for at least the near term. These changing market dynamics are creating an increasing need for rescue financing that strikes a balance between the demands of companies in need of cash, sponsors and increasingly cautious lenders, according to market participants who have been involved in structuring recent deals.
A resurgence in PIK loans
Responding to the new environment, some PE firms are renewing their appetite for alternative financing tools that can strengthen a company’s financial position. PIK loans, a hybrid security between pure debt and pure equity, are one of the rescue financing products that have experienced a resurgence recently, according to Emanuel Grillo, who heads the North American restructuring practice at Allen & Overy.
“What’s happening in the market is some weak companies in various PE portfolios are coming under stress and need more cash, and the concern is in the current marketplace where and how they get cash,” he said. “So, sponsors have to advance new funds, and they prefer to put the money in as debt because it’s new dollars and there is a fair amount of risk associated with them.”
“You are going to see [sponsors offer] a lot of junior-lien rescue financing to keep their senior lenders happy,” he added.
There has been an increased use of PIK loans in the middle market this year, in particular during the second quarter, by PE sponsors injecting money into cash-strained portfolio companies, Grillo said.
PIK, or payment-in-kind debt, allows borrowers to defer interest payments, which can be paid via the issuance of more securities rather than with cash. By taking on such instruments, borrowers can avoid triggering immediate cash outlays in the short term and preserve liquidity during periods of financial distress.
PIK issuance is typically a symptom of frothy valuations, for which yield-hungry investors are willing to be subordinated to existing debt and take on 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 save them from the burden of additional debt service, at least in the short or medium term, Grillo said.
In addition, other types of products such as preferred equity can also be used as a rescue financing tool, said Gregory Bauer, a leveraged finance attorney at Ropes & Gray.
“Sponsors tend to bring preferred equity or PIK HoldCo notes in as additional capital in the rescue situation, because they are not required to hold a talk with other lenders and are adding capital in a way that won’t be restricted by the senior credit facility that’s already in the capital stack,” Bauer said.
Such transactions gained traction during the pandemic’s peak, when PE firms stepped in to provide liquidity to troubled private and public companies by offering rescue financing tools. In 2020, Roark Capital threw a lifeline to Cheesecake Factory, in a $200 million preferred stock investment, which offered a paid-in-kind dividend of 9.5%.
And in April 2020, Providence Equity Partners and Ares Management purchased $400 million in Outfront Media convertible preferred stock. In another case, Great Hill Partners and Charlesbank Capital Partners purchased in the $535 million convertible senior notes issued by online furniture retailer Wayfair, which have paid-in-kind interest.
A cautious view
However, by saddling companies with more debt, some of these rescue financing deals could turn out to be a financial burden.
In 2014, TPG provided financially stressed yogurt maker Chobani with a rescue loan, in the form of a $750 million second-lien term loan at 5% cash interest and 8% payment-in-kind. The debt package also offers TPG warrants that can be converted into equity. Since then, Chobani has tried a number of refinancings to extricate itself from the costly arrangement and eventually did so by bringing on a new investor, the Healthcare of Ontario Pension Plan, according to media reports.
Credit analysts at S&P have forecast a slight increase in corporate borrowers defaulting on their debt obligations in coming months. Default rates among higher-risk companies could reach 3% for the 12 months ending March 2023, compared with the 1.4% default rate through March 2022, according to the rating agency.
Banks and some private credit investors have already started to take a more cautious view of deal making as they evaluate how financial uncertainty is likely to affect credit the worthiness of their borrowers. With a tightening credit market and a weakened SPAC market, some troubled companies are having more difficulties accessing cheap financing options.
“There is still a lot of liquidity in the market to deploy; however, the circumstances have changed in that borrowers are now in different positions, where they don’t have the flexibility to negotiate more favorable terms and something that makes better sense for them, because they are squeezed for cash in a way that they had not been for years,” said James Van Horn, an attorney at Barnes & Thornburg and a specialist in restructuring and insolvency.
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