OMG – THEY’RE BACK! This financial weapon of mass destruction is being deployed again! Find out how dangerous these are to your financial future here.

At face value, one the of the biggest football clubs on earth and credit creation seem like unlikely bedfellows.

When you think of Manchester United, one of the world’s largest and most glamorous clubs, you normally think of the dazzling skills of an Eric Cantona, the passing ability of David Beckham or the technical wizardry of a George Best.

You don’t think of it in terms of the real estate cycle, or financial crises, or of it being at the heart of the rottenness in the financial system that brought the world to the brink of collapse in 2008.

But it was. In 2005, it was acquired in a leveraged buyout by private investors, using a deadly set of financial instruments.

This is an area of the debt markets that flies under the radar. And frankly, that is how they prefer it too. The “they” I’m referring to is global private credit markets, which back in 2005 were called structured finance.

And what I’ve started to realize is beginning to scare me. Because what occurred during the Manchester United buy-out this time last cycle is about to occur again.

One of the long term aims of the PSE team is to discover and track just what breaks out on the margins when boom turns into bust. Have I found it here within the murky world of private credit?

Is this the canary in the coalmine? Your signal to get yourself completely out of debt and hunker down to withstand the worst the coming financial meltdown will bring to the world?

To find out for sure we must delve into the murky world of private credit.

The last time the world experienced a land-price led recession was back in 2008. As the credit tide receded and global liquidity dried up, you began to see the excesses of the credit system exposed.

Almost nowhere were the excesses as extreme as those rolled out by the biggest private equity firms, juiced up by various financial instruments that lenders were only too happy to make available. In fact, it was one such instrument that caused immeasurable damage that gained infamy at this time.

They were called payments-in-kind, or PIK, notes. And these were the debt tools with which the Glazer family ultimately bought what was, in 2005, the biggest football club on earth – Manchester United.

This was an era of leveraged buyouts that saw companies all over the world, including many English Premier League clubs, brought up by new owners using excessive debt. But the numbers required by the Glazers were eye-watering back then.

A combination of half a billion in debt and $272 million in cash was required to complete the purchase of the club. As usual, the true state of affairs only emerged when everything collapsed.

As the last fully completed real estate cycle entered its final rock-bottom years, the truth about the buyout was exposed. The $272 million in “cash” was actually provided by the Glazers remortgaging 25 of their shopping centres in the six months before the takeover.

The Glazer family’s main assets are their shopping centre businesses in America, First Allied Corporation, along with Manchester United and the Tampa Bay Buccaneers. It was later discovered they were borrowing against these assets right at the peak of the cycle.

The Glazers’ shopping mall mortgages had been bundled with other loans as Commercial Mortgage-Backed Securities on 63 of 64 First Allied shopping centres, totalling £388m ($570m).

Most of those were taken out with Lehman Brothers before the US investment banking giant went bankrupt, triggering the global banking crisis in 2008.

By 2010, most of these shopping malls were negative-geared assets. The loans outstanding were higher than the collateral those same loans were pledged against.

However, the single biggest issue for the glazers in 2010 was a certain type of debt totaling around $200 million and held against the football club.

Now, we need to take a step back here. Let me explain to you exactly what payment-in-kind (PIK) notes are.

In layman terms, these PIK notes are a tool which private lenders can provide direct to businesses. They are usually available on different terms to the more traditional bank lending.

They offer the borrower the ability to obtain a loan but defer the interest rate payments to a later date. This in-built feature means companies can improve their cash flow position whilst still accessing badly needed credit to expand or grow.

In the right circumstances they can be a useful tool, for example a strong start-up company with good growth prospects.

It’s better off reinvesting any spare cash into the business to grow rapidly. When it starts to generate cash, it can pay back or service the (now) much larger loan more easily because it’s a much larger company.

But there’s a catch: to facilitate these deferrals, they come with a higher interest rate on a mounting debt load as the deferred payments pile up.

And the deferrals are only ever temporary. At some point they come due, and the company will need to refinance the debt.

It’s no wonder some call them a “boom time instrument”.

Back in 2010, those same PIK loans worth $200 million the Glazers wrote to assist with buying Manchester United came with an eye-watering 16.25% interest rate!

Like I said, it’s only the crash and subsequent wreckage that follows where such over the top lending makes the public space. Is it any wonder why the global credit system seized up at the worst possible time?

No business can accept or meet such onerous terms during a crisis. This simply exacerbates the ongoing financial catastrophe even further.

The owners of Manchester United got away with it. Just about.  They were able to hang on until credit conditions eased enough in the 2010s to refinance their debt.

Many large companies didn’t make it back including large media and entertainment conglomerates (e.g. Tribune Group, Six Flags) and TXU Energy, which was the largest leveraged buyout in history in 2007.

PIK notes were involved in waves of corporate bankruptcies that first emerged in 2007 and continued following in the wake of the so-called Global Financial Crisis.

The Manchester United takeover took place 19 years ago when PIK notes started to come to the awareness of those who were paying attention. Given the destruction they caused in the downturn, as a financing tool they were consigned to the dustbin of history.

Or so we thought.

Incredible as it seems, these same types of debt instruments are now returning in vogue.

Only, it’s not to buy football clubs, but formerly productive companies who are short of cash.

From the above article.

A growing list of cash-strapped companies have turned to their lenders at private credit funds for relief in recent months, seeking to conserve capital by delaying payments on their debt. The rate at which companies are opting to increase their principal balance instead of paying cash, known as “payment-in-kind” or PIK, edged higher during the second quarter, according to a recent report from rating agency Moody’s.

The motivation for using PIK notes might be different this time around, but the result will be the same. This is not a healthy trend to see expanding so late in the current real estate cycle.

Moody’s records this as the highest income derived from PIK loans since 2020. The growth in these types of loans is one signal of stress in corporate America even as the broader economy expands. It’s the juxtaposition that reverbs at this late stage of each real estate cycle.

Economic expansion must be good, right? Well, agree or not, this is how the media report it to you. The stresses though are clearly compounding. A disconnect between what’s reported and the true state of the financial system occurs.

Thanks largely to the combined global central banks interest rate rise campaign which saw official cash rates rise from basically zero to above 5-6%. Many companies free cash flows have gone straight to those same interest payments on their debts.

Moody’s estimated that 7.4 per cent of the income reported by private credit funds was in the form of PIK during the most recent quarter.

Analysts at Bank of America pegged the figure at 9 per cent and said its analysis showed that these funds had gone one step further: 17 per cent of the loans they hold give the borrower an option to pay at least part of their interest with more debt going forward, even if they are not doing so now.

In other words, whilst this income only exists on paper, it can be booked into their respective accounts for the purpose of reporting to the stock market.

And so, on the surface, these private credit lenders appear quite solvent with strong future cash flows to further drive credit growth, stock price earnings and potential investors.

The issues is; it’s all just one great illusion. This sort of financial engineering only works while the economy is going strong. And investors use that sense of safety to repeat the very worst kind of blatant irresponsible lending practices which marked the peak and then bust of the last completed real estate cycle.

Don’t ever tell me that history doesn’t repeat.

So, dear reader, what you have here is a set-up of the most destructive kind, at the worst possible moment, carrying on completely under the radar. Just like last time. Some of the companies that have turned to these loans are hardly household international names.

Last time it was one of football’s true glamour clubs. Today, we are talking about private companies like Avalign Technologies and Beauty Industry Group, to name two.

They most certainly won’t mark the worst of the upcoming bust, but that’s not what we are looking for. We are looking at the margins, far away from the gaze of social and financial media.

Could these companies drowning in their unpayable PIK debts actually be the canary in the coalmine for the great unwinding of over $100 trillion in global debt markets a few years from now?

You need to watch out. This won’t happen soon, but it will happen. For the time being you need to invest sensibly because there is still money to be made. But you also need to plan properly, get your affairs in order, build cash reserves and all the rest.

You could in fact be this cycle’s Michael Burry, who brought credit default swaps (CDS) as a hedge against billions of dollars’ worth of subprime mortgage-backed securities and bonds, and later became famous for a book and movies entitled “The Big Short”.

As the land price recession began in earnest in 2008, the value of these securities fell, increasing the value of Burry’s CDS.

If that doesn’t appeal though, simply become our newest Boom Bust Bulletin (BBB) member instead!

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There is no new way to go broke, it’s always the same: there’s too much debt and it is secured against the wrong type of assets.

My issue is with dressing mutton up to look like lamb. Private credit and equity funds only want the paying public to see one thing. Increased earnings through growth and rising income levels.

Then expect you to pay through the nose to obtain some of it. Sadly, for them, I happen to know my history.

And I see the most cataclysmic of set-ups forming before my eyes. The one question remaining is this – when?

When does the debt become too much? That’s the thing that we look out for closely. And once we see it, we will let you know.

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