Credit Comment: PIK-Tock, PIK-Tock, Delaying The Inevitable Global Fixed Income Research

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1 Credit Comment: PIK-Tock, PIK-Tock, Delaying The Inevitable Global Fixed Income Research Diane Vazza, Managing Director New York (1) Cameron Miller, Associate Director New York (1) June 2008

2 Diane Vazza, Managing Director Cameron Miller, Associate Director Credit Comment: PIK-Tock, PIK-Tock, Delaying The Inevitable (Premium) NEW YORK (Standard & Poor's) June 13, 2008 The easy money conditions in the leveraged finance market in 2006 and 2007 set the ground work for a surge in issuance of pay-in-kind notes, also known as PIK-toggle notes. Many of the notes issued were in conjunction with LBO deals and were often used to finance a special divided to the private equity sponsor or common equity holders in general. PIK-toggle notes allow the issuer to pay interest with additional securities instead of with cash, which can provide the issuer with a way to preserve cash if the firm hits a rough patch. However, the feature comes at a price, as all cash interest accrues, and the coupon payment steps up at a predetermined rate. Many of the recent deals have been characterized with a 75-basis point (bp) set up in the coupon payment when the pay-in-kind feature is used. PIK-toggle notes are risky for investors because current cash flow from the instruments falls as cash interest is delayed, which, in a sense, increases the investors exposure to the firm as the interest accrues but is paid at a later date. Moreover, firms usually exercise the toggle feature when the default risk of the firm is rising (usually in a scenario where there is a need to conserve cash because of stress on earnings). PIK-toggle notes can provide firms that have high growth prospects and heavy interest burdens with the financing flexibility to avoid default during periods of declining earnings, which can be a positive for debt and equity holders alike. However, for firms with poor financial prospects, the issuance of PIK-toggle notes might only be delaying the inevitable and could likely deteriorate the recovery prospects for non-pik debt holders. In the case of PIK-toggle issuance for dividend recapitalization, this is simply a transfer of value to equity to the detriment of creditors, as leverage is increased. If the economic environment remains challenging, we expect to see more PIK-toggle notes pay in kind. PIK-toggles and covenant-lite loans, though a small part of the market, could have a noticeable impact on the default rate by both delaying defaults and providing some firms the opportunity to weather the slow down. What is concerning is that when the current cycle is over, we may very well find that PIK notes and firms that issue PIK notes have depressed instrument and firm-wide recovery values. When we examined a sample of 41 PIK-toggle notes totaling $22.9 billion in debt outstanding, we found that eight were used to fund or issued directly after a dividend recapitalization. Of the 41 PIKtoggle notes, four are currently paying in kind, and three have announced that they will pay the next coupon in kind. Key observations from this report include: Default risk is high and recovery prospects are low among our sample of PIK issuers, as most have credit ratings below B- and instrument-level ratings on the PIK instruments in the CCC to B- range. The median recovery rate (when assigned) of the PIK instruments in the sample is 6, which means Standard & Poor s Ratings Services expects negligible recovery (in the 0%-10% range) in the event of default. Only the HCA (recovery rating of 2) and Harrah s Operating Co. (recovery rating of 3) have PIK instruments with recovery ratings better than 4. Four firms--nmh Holdings Inc. (d/b/a National Mentor), US Oncology, Berry Plastics/BCP Holdings, and ipayment--are all currently paying in kind. All four firms are Credit Comment: PIK-Tock, PIK-Tock, Delaying The Inevitable 1

3 highly leveraged, with debt to EBITDA above 7.0x on a lease-adjusted basis and EBIT interest coverage below 1.0x. US Oncology, PNA Intermediate Holdings Corp., Noranda Aluminum Acquisition Corp., NMH Holdings Inc. (d/b/a National Mentor), Metals USA Holdings Corp., ipcs, ipayment, and Digicel Group all issued special dividends to equity that was either paid for by or occurred just prior to the issuance of PIK-toggle notes. US Oncology, which paid its March 2008 coupon in-kind, is a good example of a firm flipping the toggle switch as earnings declined. US Oncology issued $425 million in PIKtoggle notes in March of 2007 to partly fund a sponsor dividend, raising debt to EBITDA (adjusted for operating leases) to 6.6x. Earnings weakened in the subsequent quarter, and debt to EBITDA rose to 7.3x by Sept. 30, From the first-quarter release, US Oncology s annualized debt to EBITDA has risen to 7.9x, as EBIT declined 37.5% in the first quarter 2008 versus the first quarter of The use of increasingly complex capital structures, including the growth of second-lien and PIK-toggle note financings, will likely have an impact on recovery prospects in the reorganization process. Using ultimate recovery data on defaulted instruments from Standard & Poor s LossStats database between 1987 and the third quarter of 2007, Table 2 differentiates instrument-type recovery by whether the instrument has a PIK structure. Term loans, senior unsecured bonds, and subordinate bonds with PIK structures recovered less than their non-pik counterparts. This is not surprising, as PIK structures tend to allow firms to delay default, which often results in the continued deterioration of the firm s recovery prospects, as more debt is added and assets used as collateral depreciate further. In a few cases (revolving credit lines, senior secured bonds, and junior subordinated bonds), PIK instruments had higher recovery values than their counterparts, but this most likely related to the limitations imposed by the small sample size of PIKs (173) in the historical dataset. The issue of PIK versus non-pik recovery values will gain greater importance over the next recovery round, given that PIK structures have gained popularity over the past few years, especially among LBO-related debt offerings. This is even more pertinent because data from the last round of LBO-related defaults in the consumer products, retail, and service sectors between 1988 and 1992 show that LBOrelated defaults had lower recovery rates than non-lbo-related defaults during the same period. Credit Comment: PIK-Tock, PIK-Tock, Delaying The Inevitable 2

4 Table 1. PIK-Toggle Sample List Firm Name Issue Amount (Mil. US$) Description Instrument Rating Recovery Rating Aleris International % toggle PIK notes due 12/15/2014 B- 6 Allison Transmission % senior PIK toggle notes due 11/01/2015 B- 6 Alltel Communications % senior PIK toggle notes due 12/01/2017 B-/Watch Pos 6 AmeriPath Intermediate Holdings L+525 toggle PIK floaters due 02/15/2014 n/a n/a Berry Plastics Group, Inc.* % sr sub nts due 09/15/2016 n/a n/a Biomet % senior PIK toggle notes due 10/15/2017 B- 6 Blaze Recycling & Metals % sub pik toggles due 01/15/2013 n/a n/a % subordinated PIK toggle notes due Bonten Media Group 06/01/2015 CCC+ 6 Ceridian Corp % toggle PIK notes due 11/15/2015 CCC+ 6 Claire's Stores Inc % senior PIK toggle notes due 06/01/2015 CCC+ 5 Digicel Group % senior PIK toggle notes due 01/15/2015 n/a n/a Dollar General Inc % sub PIK toggles due 07/15/2017 CCC+ 6 Freescale Semiconductor Inc % toggle pik notes due 12/15/2014 B- 6 General Nutrition Centers Inc L+450 senior PIK toggle floaters due 03/15/2014 CCC 6 Goodman Global % split-pik toggles due 02/15/2016 n/a n/a Harrah's Operating Co. Inc % senior PIK toggles due 02/01/2018 B+ 3 Hawker Beechcraft Acquisition Company % toggle PIK notes due 04/01/2015 B % secured toggle PIK 2nd lien notes due HCA Inc. 11/15/2016 BB- 2 ipayment* % toggle pik notes due 07/15/2014 n/a n/a ipcs L+325 second-lien secured notes due 05/01/2014 CCC 6 Laureate Education Inc % toggle PIK due 08/15/2015 B- 5 Local TV Finance % senior PIK toggle notes due 06/15/2015 CCC+ 6 Metals USA L+600 step-up PIK toggle floaters due 01/15/2012 n/a n/a Metals USA Holdings Corp L+600 step-up PIK toggle FRNs due 07/01/2012 CCC/Watch Pos 6 Momentive Performance Materials Inc % senior pik toggle notes due 12/01/2014 B 4 Neiman Marcus Group Inc. (The) % senior toggle PIK notes due 10/15/2015 B+ 5 Newport Television LLC, Newport Television Holdings LLC % senior PIK toggle nts due 03/15/2017 CCC+ 6 NMH Holdings, Inc.* L senior PIK toggle FRNs due 06/15/2014 CCC+ 6 Noranda Aluminum Acquisition Corp L+400 senior PIK toggle floaters due 05/15/2015 B- 5 Noranda Aluminum Holdings L+575 senior PIK toggle notes due 11/15/2014 CCC+ 6 PNA Intermediate Holdings Corp L+700 toggle PIK floaters due 02/15/2013 B- 6 Catalent Pharma Solutions % senior PIK toggle notes due 04/15/2015 B 5 Realogy Corp % toggle PIK nts due 04/15/2014 B 4 Surgical Care Affiliates % senior PIK toggles due 07/15/2015 B- 5 Symbion Inc senior toggle PIK notes due 08/23/2015 CCC+ 6 Energy Futures Holdings Corp., Texas Competitive Electric Holdgs Co. LLC % sr PIK toggle notes due 11/01/2017 B- 4 Texas Competitive Electric Holdings Co. LLC % toggle PIK notes due 11/01/2016 CCC 6 United Surgical Partners International Inc % sr sub toggle nts due 05/01/2017 CCC+ 6 Universal Hospital Services Inc % second-lien PIK toggle notes due 06/01/2015 B+ 4 Univision Communications Inc % senior PIK toggle notes due 03/15/2015 CCC 6 US Oncology Inc.* L+450 step-up PIK toggle floaters due 03/15/2012 CCC+ 6 VWR Funding % senior Pik toggle notes due 07/15/2015 B- 5 *Indicates currently paying in-kind. Indicates announcement to pay in-kind next coupon. Source: Standard & Poor's LCD Group; Standard & Poor's Global Fixed Income Research. Credit Comment: PIK-Tock, PIK-Tock, Delaying The Inevitable 3

5 Table 2. Discounted Recovery Rates PIK Versus Non-PIK Instruments ( ) Instrument Type Mean % Standard Deviation Coefficient of Variation % Count Total non-piks ,067 Total PIKs Term loan Term loan (PIK) Revolving credit Revolving credit (PIK) Senior secured bonds Senior secured bonds (PIK) Senior unsecured bonds Senior unsecured bonds (PIK) Senior Subordinated bonds Senior Subordinated bonds (PIK) Subordinated bonds Subordinated bonds (PIK) Junior subordinated bonds Junior subordinated bonds (PIK) Includes only bank debt and bonds that defaulted. Source: Standard & Poor s LossStats Database, Standard & Poor s Global Fixed Income Research. Credit Comment: PIK-Tock, PIK-Tock, Delaying The Inevitable 4

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