Key Takeaways
- Highly leveraged capital structures and tight credit conditions could complicate debt maturity refinancings among speculative-grade companies.
- Refinancing with payment-in-kind (PIK) securities can ease cash flow and liquidity concerns. However, this is potentially at the expense of longer-term capital structure sustainability, which can limit ratings upside.
- We reviewed over 25 global PIK refinancing transactions that occurred in 2023 to identify the factors that distinguish companies rated in the 'B' category from those rated in the 'CCC' category.
- Key attributes of companies rated in the 'B' category include comprehensive multiyear maturity extensions, projected cash flow self-sufficiency, shareholder equity contributions, and stable business operating trends.
An Uptick In PIK Issuance
We expect issuers will continue to issue PIK securities to address liquidity issues and refinancing risks. Under tight credit conditions, we believe speculative-grade issuers, particularly those rated 'B' or 'B-', would struggle to generate free operating cash flow (FOCF) after refinancing their debt at credit spreads even modestly wider than those existing.
Chart 1
Globally, the debt maturities of companies rated 'B' or lower will increase to about $310 billion in 2025 and to about $440 billion in 2026 (see chart 2). To address these upcoming maturities, we expect these issuers will look to conserve cash and refinance through structures that permit them to pay interest with more debt instead of cash, known as PIK interest.
Across our global rated universe, we have reviewed over 25 such PIK refinancing transactions in 2023, up from seven in 2022. We expect these transactions will continue in 2024 and 2025 as debt maturities approach, credit conditions remain tight, and financial sponsors aim to bridge liquidity shortfalls and fund business turnarounds.
Chart 2
Rating upside may be limited, despite the temporary liquidity improvement, if we view the transaction as potentially compromising to long-term credit quality. PIK structures do not offer permanent solutions, only trade-offs. For example, PIK obligations that compound at high interest rates, and PIK preferred equity carrying put features are likely to be refinanced with debt paying interest in cash because they gradually increase liquidity risks over time and pressure common equity valuation if growth prospects lag. We are likely to consider preferred equity as akin to debt in our credit metrics if these terms apply (see "Credit FAQ: How We Treat Non-Common Equity When Rating Companies", published Nov. 2, 2023).
Irrespective of our treatment of PIK structures, several issuers in the 'CCC' category (see table 1) are likely to stay in that category even after refinancing due to unsustainable capital structures beyond the next 12 months. Ultimately, our ratings assessment will balance several factors that evaluate the sustainability of an issuer's capital structure and leverage reduction prospects over time.
For upward rating migration from 'B-' or 'CCC+' following a PIK refinancing, we typically expect to see a combination of:
- Comprehensive debt maturity profile extension;
- A sustainable capital structure commensurate with FOCF to service debt; and
- Stable or improving business operating trends.
Debt maturity profile
We generally require companies to have comprehensive, multiyear maturity profiles to be rated in the 'B' category with a stable outlook. Maturity extensions of any term are generally credit positive, and even shorter-term extensions may improve ratings for issuers within the 'CCC' category. However, among lower-rated companies that completed PIK refinancing transactions in 2023, companies upgraded to the 'B' category benefited from a long-dated weighted average maturity (WAM) at transaction close of 4.2 years on average.
For example, we upgraded Tampa-based health care software provider Greenway Health LLC to 'B-/Stable' from 'CCC/Negative' in November 2023 after a proposed refinancing transaction that extended its debt maturities by five years. We also viewed the business as trending positively, and we believed the company could consistently generate some positive free cash flow given the slightly lower overall cash interest expense following the financial sponsors contribution of about $125 million of preferred equity as part of the transaction. These factors supported our upgrade of the company.
Capital structure sustainability, cash flow, and liquidity
Even if debt maturities are extended long term, ratings improvement may be limited if we forecast cash flows will be insufficient to sustain the capital structure. In our review of 25 transactions, median FOCF to debt for issuers rated 'B-' or higher was roughly 400 basis points above those rated in the 'CCC' category post transaction and average leverage was lower by over 5x (see charts 3 and 4). For example, U.S.-based Carvana Co. (CCC+/Negative) remains in the 'CCC' category following its recent distressed exchange refinancing transaction that extended its debt maturities by about two years and reduced its debt load by about $1.3 billion (or 11%). This is because we believe the company's capital structure remains unsustainable. We believe the company's liquidity improvement is only temporary, and its liquidity will come under pressure once its PIK debt converts to cash interest in two years. We do not forecast the company will generate sufficient EBITDA to cover its substantial cash interest payments.
Chart 3
Chart 4
Ratings upside may also be diminished if PIK facilities are so large that they render the debt capitalization unsustainable over the long term. We expect issuers rated in the 'CCC' category following a distressed PIK refinancing will struggle to reduce leverage given the large share of compounding debt, which is, on average, in excess of 60% of the funded debt capitalization (measured as funded debt plus any preferred equity considered as debt by S&P Global Ratings; see chart 5).
Where PIK obligations are a smaller share of the total capitalization, prospects for leverage reduction over time are naturally improved. Indeed, the companies that we rate 'B-' following these transactions benefit from more modest PIK tranches of only 26% of the funded debt capitalization on average. This reflects a balance between the benefits of improved cash flow prospects and longer-term capital structure sustainability.
For example, we upgraded picture-related products and services retailer Photo Holdings LLC (doing business as Shutterfly; CCC+/Negative) to the 'CCC' category (from SD) after the company completed a debt exchange transaction in June 2023. The transaction resulted in sufficient liquidity of about $196 million to support operational needs through the first half of 2024, and we expect the company will generate positive FOCF in 2024 and 2025. However, we do not expect Shutterfly will reduce leverage to a more sustainable level in the near term because of the material increase in the company's debt balance resulting from the PIK interest. Shutterfly's new PIK facilities account for 55% of its debt capital and the compounding obligations will prevent the company from reducing leverage below 10x in 2024 and 2025.
Additionally, Luxembourg-based ink and print consumables provider Flint Group Topco Ltd. (CCC+/Stable) completed a comprehensive recapitalization in 2023 that drastically reduced its senior secured debt at the operating group and significantly improved its liquidity position. Despite our expectation for resilient performance and positive FOCF in 2023 and 2024, we still rate the company 'CCC+', reflecting our view of an unsustainable capital structure given the substantial amount of PIK facilities (accounting for about 52% of its debt capitalization) that will keep leverage at about 12x in 2024.
Chart 5
An increased common equity capitalization can improve our assessment of capital structure sustainability. Indeed, we revised our outlook on U.S.-based test developer and delivery company Prometric Holdings Inc. to positive from stable in September 2023 following its refinancing transaction. As part of the refinancing, Prometric addressed all its near-term maturities and the company's shareholders injected $120 million of equity, which demonstrates a shift to a less aggressive financial policy. The transaction removed its second-lien term loan through repayments and a conversion to equity and PIK debt instrument.
Additionally, we upgraded global events organizer Comet Bidco Ltd. to 'B-' from 'CCC+' in July 2023 following completion of a transaction, which extended its debt maturities by three years to 2027 and reduced its debt burden through redesignation of the financial sponsor's senior secured term loans into a subordinated shareholder loan provided on a PIK basis (which we consider as akin to equity and do not include in our debt calculations). We exclude the now subordinated facility provided by sponsor Blackstone from our debt metrics given that it is fully unsecured and subordinated (contractually and structurally), it is stapled to the group's common equity, and all interest will be capitalized.
Furthermore, we revised the outlook on dental practice support services provider ADMI Corp. (B-/Stable) to stable from negative in December 2023 following a transaction that extended its debt maturities to 2027 and 2028 and improved cash flow. The company's financial sponsors will be adding about $450 million in the form of PIK preferred equity, which, as per our criteria, we do not include in our adjusted debt calculations because it has credit protective terms and creates an alignment of incentives for the holder of the preferred equity to act as an equity holder rather than a creditor. These terms include no events of default, no maturity, no required cash payments, contractual subordination to debt, no guarantees or security, an interest rate below 15% + SOFR, and stapling with common equity. The company will use proceeds from the preferred equity to pay down all amounts outstanding under its revolving credit facility (RCF), partially repay its 2025 term loan, and for general corporate purposes.
Business operating trends
Ratings upside is unlikely if companies face significant business turnaround execution risks, weak demand, or secular industry challenges. Our ratings on commercial boating supplies and apparel retailer Rising Tide Holdings Inc. (doing business as West Marine; CCC+/Negative) reflect the risk that it could face default--selective or conventional--over the long term, absent sustained traction in operating performance amid a slowing economy, operational uncertainty, and high management turnover. This is despite recent completion of an out-of-court restructuring that exchanged debt for equity and extends maturities to 2028, providing time to execute turnaround initiatives.
Rising Tide's ability to generate significant sales growth and profitability remain uncertain amid our expectation for weak economic activity and persistent--though softening--inflation over the next 12 months. Moreover, we see heightened risks because of the business' seasonality and relatively short window to generate meaningful sales and cash flow, largely during the summer months when boating increases.
Florida-based quick service restaurant Burger BossCo Intermediate Inc. (CCC+/Negative) remains in the 'CCC' category despite recently completing a transaction that extended its debt maturities to 2027 and reduced its cash interest burden through debt for equity swap and the issuance of term loans with a PIK interest component. This reflects significant execution risk in its efforts to improve performance in the competitive quick service restaurant space where weaker consumer spending could be a headwind to performance, and the company will invest in enhancing its restaurant base to improve traffic.
Our ratings on U.S.-based specialty home decor retailer At Home Group Inc. (CCC/Negative) reflect the company's performance challenges amid weaker demand for home goods merchandise, negative cash flow, and very high leverage. This is despite its recent refinancing transaction that provided incremental liquidity.
Conversely, companies with stronger business attributes--including demand tailwinds, service diversification, competitive entry barriers, and highly recurring and growing revenues--like digital coupon incentive and settlements provider Inmar Inc. (B-/Stable), have better visibility into growth prospects to support their increasing PIK obligations.
PIK Issuance Outside Of Our Rated Universe
Outside of our rated universe, these types of structures will be more prevalent for middle market or early-stage companies in growth mode. The PIK feature is not offered in the broadly syndicated loan market given the structural requirements of collateralized loan obligations (CLOs), which are the largest source of demand for loans. While there are some exceptions, CLOs can typically only buy 5% or less of assets that can PIK and cannot buy assets that are currently deferring. Once the issuer opts to fully PIK on a sustained basis, a CLO usually treats the loan as noncurrent.
Covenant relief is also offered by lenders in the private credit market through a switch to PIK interest for issuers undergoing stress, as this lets lenders avoid a loan default or nonaccrual within the portfolio. Private credit lenders may also be willing to inject capital for issuers to satisfy the minimum liquidity covenant in their existing credit facilities.
Related Research
- U.S. Corporate Credit Outlook 2024: A Bumpy Ride To A Soft Landing, Jan. 29, 2024
- Economic Outlook U.S. Q1 2024: Cooling Off But Not Breaking, Nov. 27, 2023
- U.S. Leveraged Finance Q3 2023 Update: The Lowdown On High Interest Rates, Nov. 9 ,2023
- The Treatment Of Non-Common Equity Financing In Nonfinancial Corporate Entities, April 29, 2014
This report does not constitute a rating action.
| Primary Credit Analyst: | Ben Hirsch, CFA, New York + 1 (212) 438 0240; ben.hirsch@spglobal.com |
| Secondary Contacts: | Minesh Patel, CFA, New York + 1 (212) 438 6410; minesh.patel@spglobal.com |
| Nishit K Madlani, New York + 1 (212) 438 4070; nishit.madlani@spglobal.com | |
| Ila Maheshwari, Pune; ila.maheshwari@spglobal.com |
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