The private equity owners of French electrical equipment distributor Rexel plan to raise €1bn ($1.26bn) using a controversial financing tool, according to a source close to the deal.

The payment-in-kind note would be issued ahead of what could be the world's largest sponsor-backed flotation next year, which could value the company at €8bn. The PIK note planned by Rexel's backers, France's Eurazeo and the US's Clayton Dubilier & Rice, would be twice the size of the largest deal of its kind in Europe. These notes are a risky form of high-yield debt, mainly bought by hedge funds, which can offer a return of more than 20%, compared with a high-yield average of between 7% and 9%. They are expensive for a company to issue and controversial because they offer no interest payments during the note's life, instead rolling over the payments until maturity. This means investors may take years to realise a return. Much of the money is likely to be used to pay a dividend to the backers before the company floats. PIKs are generally the lowest ranked debt issued by a company, which in the event of collapse means holders are unlikely to get their money back. They have become more popular in Europe over the past two years, and have been used by companies as diverse as UK football club Manchester United and Dutch media company VNU. Channel Tunnel operator Eurotunnel was rumoured to be considering using them. The largest European PIK was a €500m issue sold last year by Weather Investments, which used the money to part-fund its €12.1bn purchase of Italian telecoms group Wind. But while no European company has attempted to sell a €1bn PIK note before, traders are confident there is sufficient investor appetite. A head of high yield trading said: "Timing wise this is perfect – investor appetite for the paper has never been higher. Rexel is a name people like and has strong enough cashflows to support the transaction." Last week, Brake Brothers, a UK catering group bought in 2002 by Clayton, Dubilier & Rice, sold a £275m (€410m) PIK to finance the company's pension deficit and repay a shareholder loan. The deal attracted more than £800m of orders. Several private equity firms have sold PIK notes in a company ahead of flotation. Last year the backers, which included Eurazeo, of French satellite communications group Eutelsat, sold a €300m PIK seven months ahead of its float to help pay themselves a €2.25bn dividend. Last month, Financial News reported that Rexel was preparing Europe's largest flotation by a private equity-backed company, expected to raise at least €3bn. Rexel's backers are likely to use some of the money from the float, which is scheduled for the first quarter of next year, to repay the PIK, providing an added attraction to investors as it would guarantee a quick return. BNP Paribas and Merrill Lynch are likely to win bookrunner roles on the flotation while Goldman Sachs, HSBC, JP Morgan and Morgan Stanley are also strong contenders, according to bankers. The final decision on the banks is expected "imminently", according to one banker, whose employer is pitching for the deal. The float would exceed the £1.23bn raised in 2003 by UK telephone directory group Yell to become the largest private equity-backed European flotation and could become the world's largest, beating Japan's Shinsei Bank's $2.37bn (€1.87bn) initial public offering in 2004. Eurazeo and Clayton Dubilier & Rice were unavailable for comment. Rexel declined to comment.