All things equal: would a sponsor rather have an increase of 3% in cash interest or PIK interest?

A friend gave me this question, but we couldn't quite agree. Not looking for a quantitative answer so let's not get wild with assumptions chasing a number, but for illustration's sake, let's say we're talking about a subordinated note with a base of 10% cash interest. If given the option, would the sponsor rather it become 13% cash interest or 10% cash + 3% PIK?

A friend gave me this question, but we differed a little on the answer. Here's my thinking:

A sponsor would rather have the increase in cash interest. An increase in PIK debt does increase your cash but (1) assuming you've got a sweep on more senior debt, the cash increase from the PIK is used to pay down less expensive debt. And (2) you'll have a greater net debt balance at the exit that decreases equity.

If there's no cash sweep then you could probably invest the cash in something with a better return than the present value of the extra interest, but that's probably not realistic. Our argument essentially ended at this: the correct answer is so dependent on certain variables (sweep, other investment opportunities, timing of cash flows, etc.) that "all things equal" isn't really a fair way to give the question.


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Comments (3)

Best Response
Feb 8, 2018 - 9:28pm

"Our argument essentially ended at this: the correct answer is so dependent on certain variables (sweep, other investment opportunities, timing of cash flows, etc.) that "all things equal" isn't really a fair way to give the question."

This is probably the best answer though it's not really satisfactory wrt exploring a hypothetical argument.

I was leaning toward PIK - here's why: a sponsor that gets a cash distribution usually cannot reinvest it, unless it has a capital recycling provision in its fund docs (not sure how common or uncommon these are, but usually they only apply for the first few years of a PE fund's life). Once a cash is distributed from portco to sponsor, the sponsor can either hang onto it or distribute to LPs, but usually not reinvest, so the "other investment opportunities" from the sponsor perspective essentially doesn't exist. But obviously if it leaves the capital outstanding via PIK, it can accrue and at least earn some return. I guess this is also a nuanced answer based on how PE funds work, because this answer wouldn't apply if say it was a HF or a family investment office since they can and do recycle capital.

Feb 8, 2018 - 10:53pm

I think he meant the cash from the PIK would stay with the company and the company could invest it in Capex or Acquisitions. I think the question would depend on the viability of those options. Many credit agreements require companies to sweep a certain amount of cash, so sponsors usually kind of work around it by spending it on the two things listed above. With the PIK, assuming your mandatory amortization and cash interest would be calc'd off the total balance including accrued interest, you're cash flow would still take a hit. Not as much as if the cash interest went up by 3%, but still meaningful i'd assume.

Feb 10, 2018 - 3:45am

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