As Apollo Investment Corp. (NASDAQ:AINV) works to diversify its business and cash in on some of its older investments, it has a secondary goal: generate more cash. Most of the assets Apollo owns pay the company interest and dividends. But a relatively large portion of its income -- about 9% of revenue last quarter -- came from a relatively obscure type of security: payment-in-kind, or PIK, securities.
PIK investments are a different animal than what most investors are used to. Unlike a traditional loan, the interest paid on a PIK loan might be paid all, or in part, by rolling over the interest into the loan balance.
For simplicity's sake, consider a PIK debt investment with a 10% interest rate, paid annually. On origination, the balance might be $100 million. After year one, the accrued interest would make the balance $110 million, then $121 million, and so on. It compounds as time goes on.
PIK interest is fine. There are reasons for it. Some borrowers want the flexibility to make cash or PIK payments at their request. But there are a couple of inherent dangers with PIK, one of which relates directly to BDCs like Apollo Investment.
First, if you never collect on a PIK note when it comes due, you'll lose the entirety of your investment. Cash-paying debt securities are "safer," in the sense that the interest payments between origination and default at least cover some of the lost principal. Besides, it's good to see a borrower "check in" with a cash payment every once in a while.
Secondly, and more importantly, BDCs are required by law to pay out 90% or more of their taxable income. Thus, BDCs have to pay out a cash dividend to distribute PIK earnings that weren't earned in cash. This problem is magnified if the borrower doesn't pay in full, as the BDC has paid out cash for dividends based on earnings it never really earned in cash.
Let's go back
Taking a step back to Apollo Investment Corp. and its portfolio, we can look at its filings to understand why the company wants to dispose of its PIK assets to invest in cash-paying assets. In its annual report, the company disclosed earning $31 million in PIK interest for the full 2015 fiscal year. It earned $433.6 in total investment income -- basically, top-line revenue -- and $228 million in net investment income -- basically, earnings less gains or losses.
Thus, a full 7.2% of revenue, and 13.6% of earnings, were PIK. That's a hefty chunk of money that Apollo needs to distribute as cash, despite never receiving cash.
It's making progress. For instance, in the most recent quarter, it sold a portfolio company, Playpower, which was a huge source of PIK income. On the conference call, the CEO noted that PIK would have made up 7% of revenue if Playpower were excluded compared to the actual amount, which was 9% for that quarter.
Speaking of Playpower...
Playpower is a good one to talk about because it had its own little PIK surprise. In December, Apollo Investment valued its investment at about $16.6 million higher than it valued it in March, right before the sale. It turns out the buyers weren't willing to pay what Apollo Investment thought they might pay just months before.
What happened? Probably a nasty case of the PIK disease, combined with some rosy assumptions about its value.
It's notable that, by the end of March, the preferred equity portion of the PlayPower investment had accrued about $10.2 million in PIK through its life. Apollo impaired Playpower's common equity value by $16.6 million, which partially accounts for the $10.2 million PIK accrued on the preferred equity.
And therein you'll find the primary issue with PIK; It's easy to accrue. It's easy to believe you'll be paid for it. It's great to pay dividends to your shareholders based on it. But at the end of the day, what really matters is cash, and when it comes to BDCs, it's the cash dividends that are king.
Management suggested that the roughly $115 million or so it receives from selling Playpower will be used for new, cash-paying assets. Given Apollo's hefty PIK earnings, that's certainly good to see.