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Carvana, the online used car merchant, recently reported a quarter of significant free cash flow after lengthy losses. Slashing operating costs played a part. But some sleight of hand involving a debt restructuring was also crucial.
The company and bondholders agreed on a debt swap earlier in 2023. The new notes came with a feature that required hefty increases in interest expenses. However, that bump came from adding to the principal balance, rather than via regular cash payments.
So called “payments-in-kind” interest, along with the broader debt workout, are forecast to slash annual cash servicing costs by nearly $500mn for Carvana.
Increasingly, companies are turning to PIK debt to preserve cash. Creditors including private credit funds, are happy to accept the delay to returns. But the breathing room will not be enough for many companies.
Earlier this year, flexible workspace group WeWork slashed its debt balance by around a quarter and switched most of its interest expense to PIK delivery. It filed for bankruptcy within months, even so. A cash saving could not fix its deep structural problems.
Switching interest costs from cash due today to principal due tomorrow should not inherently change a company’s valuation. However, cash saved today can be invested in growing the business — with a pay-off hoped for in future.
Unfortunately, PIK debt does not come cheap. In the instance of Carvana, the tranches of PIK notes accrue in-kind interest at annual rates of 12-14 per cent.
When switched back to cash, the rates are a few percentage points lower. Analysts at Creditsight note that when interest changes back into cash in two years at Carvana, they will exceed their prior level.
For patient bondholders and lenders, PIK debt can be a worthwhile trade. They avoid a messy bankruptcy and increase their ownership claim if a Chapter 11 comes along later.
Companies, however, should remain wary of a “finance now, pay later” ethos which may hurt them more in the long run.
The Lex team is interested in hearing more from readers. Please tell us what you think of PIK-driven restructurings in the comments section below.
