Boom-era credit deals raise fears of overheating

Pik-toggles, CLOs and cov-lites make credit market return

Neiman Marcus, the upscale US department store chain, is no stranger to fashion trends. But in the autumn of 2005 the luxury retailer started a very different kind of fad – this time for an unusual new bond structure known as a “payment-in-kind toggle”.

Pik-toggle notes, as they became known, gave Neiman Marcus the option to pay its lenders with more bonds instead of cash if the retailer ever ran into financial difficulty. For a company that was at the time being bought by private equity giants TPG and Warburg Pincus, in a leveraged buyout involving about $4.3bn worth of debt, that additional financial flexibility was considered a savvy move.

Pik notes proliferated over the course of the next three years, until the financial crisis led many borrowers – including Neiman Marcus – to “toggle” the bonds. The luxury retailer ultimately saved almost $10m every quarter by paying its lenders with debt instead of cash but left disappointed investors in its wake.

Now, eight years since the Pik-toggle entered the market, companies are again using the esoteric structures, along with a host of riskier borrowing practices associated with the buyout boom that helped inflate the 2006-07 credit bubble.

That has fuelled concerns that the return of practices last seen before the financial crisis could be indicative of overheating in credit markets.

Last week, Neiman Marcus sold $600m of Pik-toggle notes to help finance its sale by TPG and Warburg to new owners – bringing the evolution of the Pik-toggle full-circle. Other companies to have recently sold Pik-toggle notes include Checkers and Rally’s, the drive-through restaurants, and Ancestry.com.

“We’re in the third year of the greatest leveraged finance markets of all time because of the efforts by the Fed, and all the central banks around the world, to keep rates at zero,” said Craig Packer, who helped build the first Neiman Pik-toggle and is now head of leveraged finance at Goldman Sachs.

The return of Pik-toggles and other lending practices is symptomatic of a wider trend in the capital markets. With interest rates hovering at record lows, highly indebted companies have been able to sell their debt at ultra-low prices, and on terms that they dictate, to investors who are increasingly starved for yield.

Already the amount of indebtedness in leveraged buyout deals is creeping up.

The average amount of debt used to finance LBOs has jumped from a low of 3.69 times earnings in 2009 to an average 5.37 so far this year, according to data from S&P Capital IQ. At the height of the LBO boom, average leverage was 6.05.

The $6bn sale of Neiman Marcus to Ares and a Canadian pension fund is expected to leave the retailer with a debt of about seven times earnings.

At the same time, more than $200bn of “cov-lite” loans have been sold so far this year, eclipsing the $100bn issued in 2007. That means 56 per cent of new leveraged loans now come with fewer protections for lenders than normal loans.

Bankers say much of that issuance has been a result of the return of another pre-crisis market vehicle – the collateralised loan obligation. CLOs buy up leveraged loans and slice them into pieces that can be tailored to the risk appetite of a variety of investors – from big pension funds to small banks.

Like the rest of the leveraged loan market, CLOs have enjoyed buoyant demand. At least $55.41bn of the vehicles have been sold this year – the highest amount since the $88.94bn issued in 2007.

Meanwhile, at $9.2bn, the amount of Pik structures sold as part of new bond deals this year has surpassed the $6.7bn issued in the course of 2012.

The number of deals involving Pik-toggle notes will continue to increase, says Matt Toms of ING Investment Management. But with default rates below historic averages and abundant credit, there is little indication that companies will face difficulty meeting debt payments or refinancing obligations, he adds.

We all know how this story ends. The question is trying to figure out exactly when

Matt Toms, ING Investment Management

But the effervescent mood in credit markets could change quickly.

Regulators are closely scrutinising credit institutions’ lending, with the Office of the Comptroller of the Currency having criticised 42 per cent of the leveraged lending portfolio in its last review.

Proposed rules that would force CLO managers to keep a portion of a securitised deal – known as risk retention – could eventually damp demand for leveraged loans. CLOs account for about 55 per cent of demand.

Perhaps the thing that could pour water on the leveraged loan boom the fastest is the prospect of the Fed’s historic low interest rates coming to a sudden end.

“We are at the beginning of a releveraging cycle,” Mr Toms says. “Ultimately, we all know how this story ends. The question is trying to figure out exactly when.”

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