Millennials Benefit from Venture Capital, Feel Guilty (Long Subsidies)

Oh man. THIS. Is. Precious. Herein a Wall Street Journal writer feels guilty about the secondary effects of his penchant for cheap home food delivery, two-day shipping, unlimited movies for $9.99/month and 100-day mattress trials. He asks:

These “Where’s the catch?” deals are practically everywhere now, each causing me a similar dilemma:

*I take Uber Pools home at night, knowing even if nobody else gets in the car the ride’s still going to be cheaper. Are we stiffing drivers?

*I let MoviePass buy me tickets for next to nothing when I used to gladly pay full price. Will this contribute further to the decline in nonsuperhero Hollywood films?

*I demand two-day shipping for everything I buy on Amazon. Am I destroying the Earth, one cardboard box at a time?

*I use the Blue Apron free trial, cancel it and switch to HelloFresh , then rinse and repeat with Sun Basket and Plated. Can decent, easy food delivery survive?

We almost mistook this for an Onion article.

Here are some answers.

Yes. Probably. Yes. No. These answers are pretty self-evident.

The very same people that the writer is concerned about affecting is riding Uber in his off time, ordering the free Blue Apron trial, and taking advantage of 2-day shipping. So, nothing to worry about there.

As for it being a “deal”? We’re giving away our data every single time we eat a subsidized meal, take a subsidized ride, or recycle an extra cardboard box. Isn’t that information valuable? Isn’t there a whole world of people hacking away trying to obtain it? If you’re not paying for the product, you are the product. Not sure that’s such a great deal, in the end.

So, with that said, we’re now going to do this:

That’s right: $20/month.

Ah, co-working.

🚗Will California Jumpstart Electric Vehicles?🚗

Electric Vehicles (Short Musk-Related Noise; Long Technology)

This is not a fangirl ode to Elon Musk. We’ll leave that to the Twittersphere. The trials and tribulations of everyone’s favorite Marvel-character-inspiring eccentric billionaire may be distracting from developments far bigger and far badder than Tesla’s ($TSLA) balance sheet: the advancement of electric vehicles.

Last week, California’s state legislature approved a bill that requires the state — subject to Governor Jerry Brown’s signature — to get 100% of its electricity from carbon-free sources by 2045. Yes, 2045 — 27 years from now. Sure, it might be hard for you to be impressed or to care. If PETITION is even still around by then it will likely be written by artificial intelligence bots. So, we get it.

Still, California ALREADY gets 29% of its electricity from zero-carbon wind, solar, biomass and geothermal energy — in part to dramatically reduce greenhouse gas emissions and in part, no doubt, to flick off the President of the United States. Indeed, greenhouse gas emission levels have decreased such that they now rival those of the 1990s.

Yet, emission levels related to transportation in California have barely moved. Nevertheless, consistent with what we wrote previously about advancements in the auto space, Nathanial Bullard notes that that appears primed to change. In a piece entitled “Electric Vehicles’ Day Will Come, and It Might Come Suddenly,” he wrote:

In the first half of the year, vehicles with a battery were more than 10 percent of new vehicle sales in California. The model mix includes hybrids like the Toyota Prius that have no electric charging plugs, as well as plug-in hybrids and pure electric cars with no combustion engine at all.

The data reveal three trends. The first is the steady erosion of hybrid market share, which is down from seven percent of new sales in 2013 to four percent in the first half of 2018. That’s noteworthy, and so is the fact that battery electric vehicles are now more popular than plug-in hybrids.

In 2017, the plug-in electric car market is now more than six percent of new car sales in California. It’s not a big number — but it will get bigger, and it’s worth asking, “how much bigger?”

Looking at Norway, Bullard posits that it can get substantially bigger. He notes that:

It took Norway about a decade to reach six percent electric vehicle sales but then only five years to go from 6 percent to 47 percent. 

Is 6% some sort of magical inflection point for electric vehicles? Debatable. Norway is super-progressive when it comes to the environment; it also offers extensive incentives to encourage EV adoption. But with a statewide push towards zero-carbon electricity, a push towards zero-emission electric cars may not be far behind. Californian car sales are pushing towards 2 million in 2018. And selection is about to improve: everyone from Audito BMW to Porsche are coming out with all-electric models in the next several years. Tremendous growth may not be too far off. The OEMs — Tesla’s competitors — are making sure of it.

*****

Speaking of technological advancement in auto (and auto distress), we find Andreesen Horowitz’s Benedict Evans’ musings on the topic to be thoughtful and thought-provoking. We previously wrote about him WAY back in January 2017 when he wrote about mobile eating the world. The piece is worth revisiting.

Last week, he released a new piece with questions right up our alley. He asked:

…what happens when ‘software eats the world’ in general, and when tech moves into new industries. How do we think about whether something is disruptive? If it is, who exactly gets disrupted? And does that disruption…mean one company wins in the new world? Which one?

He seems to conclude the following: not Tesla.

One narrative surrounding Tesla in the post-Solar City acquisition world is that it more than just a car company: it’s a battery play. Musk’s powerwall feeds this narrative. SolarCity, to some degree, feeds this narrative. But Evans begs to differ; he thinks the battery — as well as EV components, generally — will become commodities. Commodities that spawn victims along the way. He notes:

It’s probably useful here to compare batteries in particular with the capacitive multitouch screens in a smartphone. Apple was the first to popularise these screens, and arguably still implements them best, and these screens fundamentally changed how you made a phone, but the whole industry adopted them. There are better and worse versions, but everyone can buy these screens now, and making a multitouch phone by itself is not a competitive advantage.

It’s pretty clear that electric disrupts the internal combustion engine, and everything associated with it. It’s not just that you replace the internal combustion engine with electric motors and the fuel tank with batteries - rather, you remove the whole drive train and replace it with sometime with 5 to 10 times fewer moving or breakable parts. You rip the spine out of the car. This is very disruptive to anyone in the engine business - it disrupts machine tools, and many of the suppliers of these components to the OEMs. A lot of the supplier base will change. 

This is not the same as disrupting the OEMs themselves. If the OEMs can buy the components of an electric car as easily as anyone else, then the advantage in efficient scale manufacturing goes to the people who already have a lead in efficient scale manufacturing, since they’re doing essentially the same thing. In other words, it’s the same business, with some different suppliers, and electric per se looks a lot more like sustaining innovation. (emphasis added) 

Likewise, he highlights how Tesla’s (i) software, (ii) data aggregation and (iii) efforts with autonomous driving may be leading now but they may not be as disruptive, in the truest sense of the term, to competitor OEMs as some might believe. That is, many OEMs are making progress of their own in those areas. The lead is not that wide. Tesla’s moat is not vast. Read the piece: he raises some interesting points — too many to note here.

He concludes:

…the history of the tech industry is full of companies where having a lovely product, or being the first to see or build the future, were not enough. Indeed, the car industry is the same - a great, innovative car and a great car company are not the same thing. Tesla owners love their cars. I loved my Palm V, and my Nokia Lumia, and my father loved his Saab 9000. But being first isn’t enough and having a great product isn’t enough - you have to try to think about how this fits into all the broader systems. 

Indeed. Many companies — many of which seem wildly successful today — will falter as that system develops.

What to Make of the Credit Cycle Part 12 (Long Yield, Baby, Yield).

The Rise of Litigation Finance

Investors have to generate yield somewhere. Hence, as we’ve discussed ad nauseum, the rise of alternative investment avenues such as venture capital and litigation finance. Wait. Litigation finance? Yes. Think Peter Thiel, Hulk Hogan and Gawker. This is a booming space.

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💥Clash of Titans: Biglaw vs. PE Direct Lender💥

Professional Fees (Long Nasty Records)

 Source

We expect to see more disputes over professional fees as (i) rates continue to rise into the stratosphere and (ii) large asset management firms try to exert their considerable pull. The good thing is that the rest of us can just sit back, pop some popcorn and put our feet up. A brawl between biglaw and a direct lender is WAY more entertaining than, say, Pacific Rim.

Late last week, Cerberus Business Finance LLC (“CBF”) gave Hughes Hubbard & Reed LLP (“HH&R”) some light weekend reading when it objected to the firm’s fees in the Patriot National Inc. (“PN”) case — an objection that Cerberus said “will not come as a surprise to Hughes Hubbard.” Cerberus stated (Docket 1001):

Given the Debtors' obvious financial distress and substantial cash needs for operations, CBF very vocally expressed its concerns regarding the potential magnitude of all professional fees and the need to manage them and keep them under control. Among other things, CBF specifically questioned whether these cases were "too small" for Hughes Hubbard, and whether it would more efficient and cost effective for the Debtors to be represented by a firm with a Delaware office and significant experience representing Chapter 11 debtors. Hughes Hubbard (who had previously been counsel to the Board of Directors of Patriot National, Inc. and choreographed the termination of the Debtors' prior counsel in order to take on that role themselves) was party to those discussions with CBF, was thus acutely aware of CBF's concerns, and at the request of CBF provided- and agree to abide by - a specific line-item budget relating to the performance of legal services for the Debtors. Hughes Hubbard also agreed that prior to incurring fees beyond the agreed budget (whether for unforeseen events or otherwise), Hughes Hubbard would seek the approval of the Debtors and CBF.

Nothing like one paragraph that simultaneously says (i) the law firm Game of Thrones’d its way into the representation, (ii) wasn’t the first or preferred choice, (iii) is inadequately suited for debtor cases, (iv) flagrantly busted a “specific line-item budget,” and (v) didn’t adhere to its pre-petition agreement to keep the lines of communication open about fees.

Cerberus further argued that, among other things, HH&R was inefficient. It noted:

Even the most cursory review of the actual time entries evidences the fact that senior attorneys were devoting substantial time and attention to matters that more properly should have been handled by more junior attorneys or paralegals.

A law firm tried to make as much money possible? Never in a million years would we expect that to happen.

Meanwhile, we find it very interesting that it at last appears that a future owner of a company — by way of a debt for equity swap — is understanding the extent that professional choices can result in (potential) value leakage to the estate. Indeed, as the now owner of PN, CBF has every incentive to claw back HH&R’s fees because each incremental dollar that it doesn’t pay to HH&R remains with and enhances the value of PN.

And so this is precisely what HH&R focuses on in its response. Indeed, HH&R wastes no time whatsoever leading off its response by stating (Docket 1011):

The Objection should be seen for what it is: an attempt to improve Cerberus’ return on a bad investment by shifting the cost of these Chapter 11 Cases to estate professionals. Having lent close to $200 million to the Patriot Debtors only to see the business collapse within a year, Cerberus apparently is frustrated by the Bankruptcy Code’s requirement that part of the price of confirming a chapter 11 plan of reorganization is paying the professional fees incurred in achieving that result. This Objection is brought out of naked self-interest. Now that the cases are over and the Plan effective, Cerberus simply does not want to pay the fees.

Bam! Counter-punch! Nothing like one paragraph that, if we may paraphrase, essentially says (i) you’re a crappy investor, (ii) you reap what you sow, (iii) you obviously don’t read PETITION enough because you clearly didn’t recognize that bankruptcy is big business (sorry, we had to), and (iv) you’re not even remotely slick, bro.

For good measure, HH&R throws Schulte Roth & Zabel LLP under the bus, highlighting that its invoices came in well over the budgeted amount for HH&R —creating a record that it, too, is certainly no bargain.

Moreover, HH&R highlights a fundamental issue with bankruptcy cases these days: who is the client? Clearly CBF believed it to be them. HH&R begged to differ.

Speaking of clients, HH&R sure seems to be cautioning law firms about what it might expect from the way CBF does business. HH&R wrote:

Cerberus waited until after Hughes Hubbard achieved confirmation of the Debtors’ chapter 11 plan of reorganization to object to Hughes Hubbard’s fees, despite the fact that Hughes Hubbard timely filed monthly fee statements in these Cases—fee statements that made it clear from the beginning that the fees incurred were substantially more than the DIP budget envisioned. Much like the numerous other estate professionals that Cerberus has stiffed throughout these cases (except its own professionals who demanded and received prompt payment from the Debtors), Cerberus refused to fund any interim payments to Hughes Hubbard after a single payment of $364,706.

This tactic of lying in the weeds while Hughes Hubbard achieved the results Cerberus wanted and then objecting to the fees required to achieve those results is inherently dishonest. It is also fundamentally unfair. The Court should not tolerate it here.

Something tells us that CBF’s direct lending competitors will have a field day with that language. Something also tells us that HH&R won’t be servicing any companies with CBF in the cap stack anytime soon. Yes, call us Captain Obvious.

At the end of the day, we can’t believe that this dispute saw the light of day. Clearly there is no love lost between HH&R, Schulte and CBF and now the record is replete with unflattering commentary about all three. Their loss. Our gain.

🎆Lehman = Anniversary Fever🎆

Initiate the Deluge of Lehman Retrospectives (Short History)

The onslaught of “10 years ago” retrospectives about the collapse of Lehman Brothers, the “Great Recession,” and lessons learned (and not learned, as the case may be), has officially begun. Brace yourselves.

Bloomberg’s Matt Levine writes:

Next weekend marks 10 years since the day that Lehman Brothers Inc. filed for bankruptcy. I suppose you could argue for other dates being the pivotal moment of the global financial crisis, but I think most people sensibly take Lehman Day as the anniversary of the crisis. Certainly I have a vivid memory of where I was on Sept. 15, 2008 (on vacation, in Napa, very confused about why no one around me was freaking out), which is not true of, say, Bear Stearns Hedge Funds Day. So expect a lot of crisis commemoration in the next week or two.

Fair point about Bear Stearns. As we’ll note in a moment, that isn’t the only pivotal moment that is getting lost in the Lehman Brothers focus.

Anyway, Levine pokes fun at a Wall Street Journal piece entitled, “Lehman’s Last Hires Look Back.” It is worth a read if you haven’t already. The upshot: all four of the folks who started at Lehman on or around the day it went bankrupt ended up landing on their feet. In fact, it doesn’t sound like any of them really suffered much of a gap of employment, if any at all.

Levine continues:

I mean he stayed there for two and a half years and left, not because he was working for a bank that had imploded and couldn’t pay him anymore, but because he got “super jaded.” Another one “was fortunate that my position was maintained at Neuberger Berman [an investment-management firm then owned by Lehman], and I spent eight years there” — and now works for Dick Fuld at his new firm. It is all a bit eerie to read. Of course Lehman’s bankruptcy led, fairly rapidly, to many job losses in the financial industry, and particularly — of course — at Lehman.  But there is a lot of populist anger to the effect that investment bankers brought down the global economy and escaped relatively unscathed, and that anger will not be much assuaged by learning that these young bankers — who, to be fair, had nothing to do with bringing down the economy! — kept their jobs for years after Lehman’s bankruptcy and left only when they felt super jaded.

He’s got a point.

It’s not as if this is a happy anniversary and so there are a number of folks who are doubling-down on the doom and gloom. McKinsey, for instance, notes that global debt continues to grow and households have reduced debt but are still over-levered. They also note, as we’ve written previously, that (i) corporate debt serves as a large overhang (e.g., developing country debt denominated in foreign currencies, growth in junk bonds, the rise in “investment grade” BBB bonds, the resurgence of CLOs), (ii) real-estate prices are out of control and creating housing shortages, (iii) China’s growth trajectory is becoming murkier in the face of significant debt, and (iv) nobody fully knows the extent to which high-frequency trading can affect markets in a panic. They don’t even mention the possible effects of Central Banks’ tightening and unwinding QE (Jamie Dimon must be shaking his head somewhere). Nevertheless, they conclude:

The good news is that most of the world’s pockets of debt are unlikely to pose systemic risk. If any one of these potential bubbles burst, it would cause pain for a set of investors and lenders, but none seems poised to produce a 2008-style meltdown. The likelihood of contagion has been greatly reduced by the fact that the market for complex securitizations, credit-default swaps, and the like has largely evaporated (although the growth of the collateralized-loan-obligation market is an exception to this trend).

But one thing we know from history is that the next crisis will not look like the last one. If 2008 taught us anything, it’s the importance of being vigilant when times are still good.

Arturo Cifuentes writes in The Financial Times that, unfortunately, ratings agencies, insurance companies and investment executives got off relatively unscathed (in the case of the former, some fines notwithstanding). The Economist notes that housing issues, offshore dollar finance, and the post-Great Recession rise in populism (which prevents a solution to the euro’s structural problems) continue to linger. Ben BernankeTimothy Geithner and Henry Paulson Jr. worry that Congress has de-regulated too much too soon.

Others argue that the crisis made us too afraid of risk, at least initially — particularly at the individual level. And that this is why the recovery has been so slow and, in turn, populism has been on the rise. Indeed, some note that the response to the crisis is why “the system is breaking now.” And still others highlight how the return of covenant-lite is Exhibit A to the argument that memories are short and any lessons went flying right out the window. Castles in the air theory reigns supreme.

Anyway, The Wall Street Journal has a full section devoted to “The Financial Crisis: 10 Years Later” so you can drown yourself in history all you want. This Financial Times pieceresonated with us: we remember embarking on the same prophylactic personal financial protections at the time. And how eerie it was.

But what haven’t we seen much of? We would love to see “A Man in the High Castle”-like coverage of what would have happened had AIG not been bailed out and been allowed to fail. The bailout of AIG has largely been relegated to a footnote in the history of the financial crisis — much like, as Levine implied, the failure of Bear Stearns. Make no mistake, it’s undoubtedly better off that way. But remember: the AIG bailout occurred one day afterLehman Brothers bankruptcy filing. It, therefore, didn’t take long for the FED to conclude amidst the carnage of Lehman’s failure that an AIG failure would do ever-more unthinkable Purge-like damage to the international financial system. In fact, many believed at the time that, through its relationships with all of the big banks and the extensive exposure it had to credit default swaps, that AIG was more strongly correlated to the international system (and hence more dangerous) than even Lehman.

After seeing what was happening once Lehman went bankrupt, this was simply a risk that the FED wasn’t willing to take. What if they were willing? Where would the world economy look like now? It’s interesting to think about.

One last note on AIG: Lehman had 25,000 employees. AIG is currently twice that. Even from the perspective of headcount, it was literally too big to fail.

Initiate the Deluge of Lehman Retrospectives (Short History)

10 Years Have Passed Since the Great Recession. What has Changed?

The onslaught of “10 years ago” retrospectives about the collapse of Lehman Brothers, the “Great Recession,” and lessons learned (and not learned, as the case may be), has officially begun. Brace yourselves.

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💣Diebold. Disrupted.💣

Are Point-of-Sale & Self-Checkout Systems Effed (Short Diebold Nixdorf)?

Forgive us for returning to recently trodden ground. Since we wrote about Diebold Nixdorf Inc. ($DBD) in “💥Millennials & Post-Millennials are Killing ATMs💥,” there has been a flurry of activity around the name. The company…

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📱Is Tech in Trouble? Part 2.📱

Short Hefty Seed Rounds

ICYMI, in “📱Is Tech in Trouble?📱,” we asked whether…well…tech was in trouble. We aren’t alone.

A few weeks ago Brad Feld of Foundry Group wrote the following in a piece entitled, “Early Stage VCs — Be Careful Out There”:

Yesterday, in one of the quarterly updates that we get, I saw the following paragraph.

“Historically, the $10 million valuation mark has been somewhat of a ceiling for seed stage startups. But so far this year, we’ve seen that a number of companies, often times with nothing more than a team and a Powerpoint presentation, have had great success raising capital north of that $10 million level. Furthermore, round sizes continue to tick up, with many seed rounds now in the $2.5 million to $4.0 million range.”

We are seeing this also and have been talking about it internally, so it prompted me to say something about it.

I view this is a significant negative indicator.

It has happened only one other time in my investing career – in 1999.

Man. There’s so much money out there looking for some action.

Read the piece. It’s short. He closes with this:

For anyone that remembers 2000-2003, this obviously ended badly. By 2002 investments at the seed level had evaporated (there were almost no seed financings happening). In 2003 the angels started to reappear (some of the best angel deals of all time were done between 2004 and 2007) and the super angel language started to be used around 2007.

All the experienced finance people I know talk regularly about cycles. If you believe in cycles, this one feels pretty predictable. Of course, there is an opportunity in every part of the cycle. But, be careful out there.

The kinds of companies he’s talking about aren’t in the same zone as those that we wrote about last week. These early stage companies are too early to have any of the characteristics (i.e., public equity, advanced IP, leases, exposed directors) that we noted might qualify a company to leap outside of the sphere of an assignment of benefit of creditors and into bankruptcy court. But still. This piece could just as easily slide into our “What to Make of the Credit Cycle” series.

To put a cherry on top, read this piece from Jason Calacanis. We typically think Mr. Calacanis is too high on his own sh*t but this cautionary letter to the founders he’s invested in is, in fact, instructive. We particularly liked his link to a Sequoia Capital presentation circa 2008. It’s a must read for anyone who wants a primer/refresher on what the hell happened back in the financial crisis and some insight into how investors thought about the time.

Screen Shot 2018-08-18 at 2.46.57 PM.png

The upshot: he instructs his founders to do everything they can to ensure 12-18 months of runway.

So, where are we in the credit cycle? The part where a number of folks are starting to exercise and advise a bit more caution.

💰Private Equity Own Yo Sh*t (Short Health. And Care)💰

Forget Toys R Us. Private Equity Now Owns Your Eyes and Teeth

It has been over a month since media reports that Bernie Sanders and certain other Congressman questioned KKR about its role in the demise of Toys R Us (and the loss of 30k jobs). At the time, in “💥KKR Effectively Tells Bernie Sanders to Pound Sand💥,” we argued that the uproar was pretty ridiculous — even if we do hope that, in the end, we are wrong and that there’s some resolution for all of those folks who relied upon promises of severance payments. Remember: KKR declared that it is back-channeling with interested parties to come to some sort of resolution that will assuage people’s hurt feelings (and pocketbooks). Since then: we’ve heard nothing but crickets.

This shouldn’t surprise anyone. What might, however, is the degree to which private equity money is in so many different places with such a large potential societal impact. It extends beyond just retail.

Last week Josh Brown of Ritholtz Wealth Management posted a blog post entitled, “If You’re a Seller, Sell Now. If you’re a Buyer, Wait.” Here are some choice bits (though we recommend you read the whole thing):

I’ve never seen a seller’s market quite like the one we’re in now for privately held companies. In almost any industry, especially if it’s white collar, professional services and has a recurring revenue stream. There are thirty buyers for every business and they’re paying record-breaking multiples. There are opportunities to sell and stay on to manage, or sell to cash out (and bro down). There are rollups rolling up all the things that can be rolled up.

In my own industry, private equity firms have come in to both make acquisitions as well as to back existing strategic acquirers. This isn’t brand new, but the pace is furious and the deal size is going up. I’m hearing and seeing similar things happening with medical practices and accounting firms and insurance agencies.

Anything that can be harvested for its cash flows and turned into a bond is getting bought. The competition for these “assets” is incredible, by all accounts I’ve heard. Money is no object.

Here’s why – low interest rates (yes they’re still low) for a decade now have pushed huge pools of capital further out onto the risk curve. They’ve also made companies that rely upon borrowing look way more profitable than they’d ordinarily be.

This can go on for awhile but not forever. And when the music stops, a lot of these rolled-up private equity creations will not end up being particularly sexy. Whether or not the pain will be greater for private vs public companies in the next recession remains to be seen.

The Institutional Investor outright calls a bubble in its recent piece, “Everything About Private Equity Reeks of Bubble. Party On!” They note:

The private equity capital-raising bonanza has at least one clear implication: inflated prices.

Buyout multiples last year climbed to a record 10.2 times earnings before interest, taxes, depreciation, and amortization, according to S&P Global Market Intelligence. This year they remained elevated at an average of 9.5 times ebitda through May, a level surpassing the 2007 peak of the precrisis buyout boom.

Screen Shot 2018-08-18 at 11.54.58 AM.png

When you’re buying assets at inflated prices/values and levering them up to fund the purchase, what could possibly go wrong?

*****

What really caught our eye is Brown’s statement about medical practices. Ownership there can be direct via outright purchases. Or they can be indirect, through loans. Which, in a rising rate environment, may ultimately turn sour.

Consider for a moment the recent news that private equity is taking over from and competing with banks in the direct lending business. KKR, Blackstone Group, Carlyle Group, Apollo Global Management LLC and Ares Management LP are all over the space, raising billions of dollars, the latter recently closing a new $10 billion fund in Q2. They’re looking at real estate, infrastructure, insurance, healthcare and hedge funds. Per The Wall Street Journal:

Direct loans are typically floating-rate, meaning they earn more in a rising-rate environment. But borrowers accustomed to low rates may be unprepared for a jump in interest costs on what’s often a big pile of debt. That risk, combined with increasingly lenient terms and the relative inexperience of some direct lenders, could become a bigger issue in a downturn.

Regulators like that banks are wary of lending to companies that don’t meet strict criteria. But they are concerned about what’s happening outside their dominion. Joseph Otting, U.S. Comptroller of the Currency, said earlier this year: “A lot of that risk didn’t go away, it was just displaced outside of the banking industry.”

What happens when the portfolio companies struggle and these loans sour? The private equity fund (or hedge fund, as the case may be) may end up becoming the business’ owner. Take Elements Behavioral Health, for instance. It is the US’s largest independent provider of drug and alcohol addiction treatment. In late July, the bankruptcy court for the District of Delaware approved the sale of it the centers to Project Build Behavioral Health, LLC, which is a investment vehicle established by, among others, prepetition lender BlueMountain Capital Management. In other words, the next time Britney Spears or Lindsay Lohan need rehab, they’ll be paying a hedge fund.

The hedge fund ownership of healthcare treatment centers thing doesn’t appear to have worked out so well in Santa Clara County.

These aren’t one-offs.

Apollo Global Management LLC ($APO) is hoping to buy LifePoint Health Inc. ($LPNT), a hospital operator in approximately 22 states, in a $5.6 billion deal. Per Reuters:

Apollo’s deal - its biggest this year - is the latest in a recent surge of public investments by U.S. private equity, the highest since the 2007-08 global financial crisis.

With a record $1 trillion in cash at their disposal, top private equity names have turned to healthcare. Just last month, KKR and Veritas Capital each snapped up publicly-listed healthcare firms in multi-billion dollar deals.

Indeed, hospital operators are alluring to investors, Cantor Fitzgerald analyst Joseph France said. Because their operations are largely U.S.-based, hospital firms benefit more from lower tax rates than the average U.S. company, and are also more insulated from global trade uncertainties, France said.

Your next hospital visit may be powered by private equity.

How about dentistry? Well, in July, Bloomberg reported KKR & Co’s purchase of Heartland Dental in that “Private Equity is Pouring Money Into a Dental Empire.” It observed:

In April, the private equity powerhouse bought a 58 percent stake that valued Heartland at a rich $2.8 billion, the latest in a series of acquisitions in the industry. Other Wall Street investment firms -- from Leonard Green & Partners to Ares Management -- are also drilling into dentistry to see if they can create their own mega chains.

Here’s a choice quote for you:

"It feels a bit like the gold rush," said Stephen Thorne, chief executive officer of Pacific Dental Services. "Some of these private equity companies think the business is easier than it really is."

Hang on. You’re saying to yourself, “dentistry?” Yes, dentistry. Remember what Brown said: recurring revenue. People are fairly vigilant about their teeth. Well, and one other big thing: yield baby yield!

The nitrous oxide fueling the frenzy is credit. Heartland was already a junk-rated company, with debt of 7.4 times earnings before interest, taxes, depreciation and amortization as of last July. KKR’s takeover pushed that to about 7.9, according to Moody’s Investors Service, which considered the company’s leverage levels "very high."

Investors were so hungry that they accepted lenient terms in providing $1 billion of the leveraged loans that back the deal, making investing in the debt even riskier.

Nevermind this aspect:

Corporate dentistry has come under fire at times for pushing unnecessary or expensive procedures. But private equity firms say they’re drawn by efficiencies the chains can bring to individual dental practices, which these days require sophisticated marketing and expensive technology. The overall market for dental services is huge: $73 billion in 2017, according to investment bank Harris Williams & Co. Companies such as Heartland pay the dentists while taking care of everything else, including advertising, staffing and equipment. (emphasis added)

Your next dental exam powered by private equity.

Sadly, the same applies to eyes. Ophthalmology practices have been infiltrated by private equity too.

Your next cataracts surgery powered by private equity.

Don’t get us wrong. Despite the fact that we harp on about private equity all of the time, we do recognize that not all of private equity is bad. Among other positives, PE fills a real societal need, providing liquidity in places that may not otherwise have access to it.

But we want some consistency. To the extent that Congressmen, members of the mainstream media and workers want to bash private equity for its role in Toys R’ Us ultimate liquidation and in the #retailapocalypse generally, they may also want to ask their emergency room doctor, dentist and ophthalmologist who cuts his or her paycheck. And double and triple check whether a recommended procedure is truly necessary to service your eyes and mouth. Or the practice’s balance sheet.

🍾Happy Anniversary, Tower Records!!🍾

Tower Records Filed for Chapter 22 on August 20, 2006 (Long Disruption)

12 years ago today Tower Records Inc. filed for bankruptcy for the second time in 2.5 years, ending the company’s run in the United States (and most other places of the world).

The company first filed for bankruptcy in February 2004. The music retailer had approximately 90 stores and more than $110mm in debt that it owed to the likes of AIG Investment Group, Goldman Sachs & Co., JPMorgan Chase and…wait for it…Bear Stearns Securities Corp. The first bankruptcy was a short prepackaged bankruptcy that eliminated $80mm of debt in a debt-for-equity swap, leaving the company’s famous and eccentric owners with 15% of the company. The company attempted a sale process but had no takers. CIT Group provided the company with a $100mm DIP credit facility. O’Melveny & Myers LLP and Richards Layton & Finger PA represented the company (and both signatories to the petition actually still remain at those firms).

Interestingly, with some limited exception, the narrative explaining the company’s demise is not-all-too-different from what we see from retailers today. SFGate wrote at the time:

Tower's difficulties reflect those of the music industry during the past few years. Industry sales declined from $10.49 billion in 1999 to $8.93 billion in 2002, according to a report from the National Association of Recording Merchandisers, which attributed the swoon to digital downloading and copying. Retailers are also under pressure from online sales by firms such as Amazon.com, and from deep discounting by such rivals as Wal-Mart, and fierce competition from other chains like Borders and Barnes & Noble.

CBSNews added:

The filing is expected to help clear the way for selling the 93-store chain that suffered from rapid changes in the music business, especially the exploding popularity of downloading music for free from the Internet. Discounters such as Best Buy, Circuit City and Wal-Mart Stores also undercut Tower's prices and hurt the chain's earnings.

Those trends and a major slump in the music industry followed fast on the heels of the company's 1998 decision to expand using $110 million of borrowed money. The expansion drove Tower to a peak of more than $1 billion in annual revenue with nearly 200 stores in 21 states and numerous franchises internationally. But it has been rapidly downsizing since 2001.

A filing last April with the U.S. Securities and Exchange Commission revealed the retailer had lost money for 13 straight quarters.

Wait. Amazon ($AMZN)? Check. Deep discounting from the likes of Walmart ($WMT)? Check. Too much debt to fund an over-expansion? Check. Revenue declines on the basis of technological innovation? Check. We guess the more things change, the more they stay the same.

And stay the same they did. Even then. It took just 2.5 years for the company to wind its way back into bankruptcy court. And for all of the same reasons. Two months later, Great American Group, a firm that specializes in liquidations, emerged as the highest and best bidder in an auction for the company, winning with a bid of $134.5mm; it beat Trans World Entertainment Corporation ($TWMC), an entertainment media retail store operator that — shockingly — still exists. You may be familiar with it: it’s largest specialty retail brand is fye, which as of May 2018, still operated 253 stores. It is hanging by a thread, but it still exists — largely on the back of its etailz segment, which apparently thrives by doing omni-channel business with Amazon, Ebay, Jet.com/Walmart and Wish.

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Anyway, Trans World had hoped to continue operating at least some of the Tower locations; it lost the bidding by $500k. And, accordingly, Tower Records liquidated. While there is such a thing as Tower Records in Asia, the name is all but a distant memory today.

#BustedTech's Secret: Assignment for the Benefit of Creditors

Long Private Markets as Public Markets

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⚡️🤓Nerd alert: we need to lay a little foundation in this one with some legal mumbo-jumbo. Consider yourself warned. Solid payoff though. Stick with it.🤓⚡️

Allow us to apologize in advance. It’s summer time and yet we’ve been nerding out more often than usual: on Sunday, we dove into net-debt short activism, for goodness sake! We know: you want to just sit on the beach and read about how Petsmart implicates John Wick. We get it. Bear with us, though, because there is a business development aspect to this bit that you may want to heed. So attention all restructuring professionals (and, peripherally, start-up founders and venture capitalists)!

Recently the Turnaround Management Association published this piece by Andrew De Camara of Sherwood Partners Inc, describing a process called an “assignment for the benefit of creditors” (aka “ABC”). It outlines in systematic fashion the pros and cons of an ABC, generally, and relative to a formal chapter 11 filing. When the bubble bursts in tech and venture capital, we fear a number of you will, sadly, become intimately familiar with the concept. But there’ll be formal bankruptcies as well. ABCs won’t cut it for a lot of these companies at this stage in the cycle.

Let’s take a step back. What is the concept? Per Mr. De Camara:

An ABC is a business liquidation device governed by state law that is available to an insolvent debtor. The ABC procedure has long existed in law and is sometimes addressed in state statutes. In an ABC, a company, referred to as the assignor, transfers all of its rights, title, and interest in its assets to an independent fiduciary known as the assignee, who liquidates the assets and distributes the net proceeds to the company’s creditors. The assignee in an ABC serves in a capacity analogous to a bankruptcy trustee in a Chapter 7 or a liquidating trustee in a Chapter 11.

He goes on to state some characteristics of an ABC:

  • Board and shareholder consent is typically required. “If a company is venture-backed, it may be required to seek specific consent from both preferred and common shareholders. It is possible to enter publicly traded companies into an ABC; however, the shareholder proxy process increases the difficulty of effectuating the ABC and results in a much longer pre-ABC planning process.”

  • There is no discharge in an ABC.

  • Key factors necessitating an ABC include (a) negative cash burn + no access to debt or equity financing, (b) lender wariness, (c) Board-level risk as a lack of liquidity threatens the ability to pay accrued payroll and taxes, and (d) diminished product viability.

And some benefits of an ABC:

  • ABC assignees have a wealth of experience conducting liquidation processes;

  • The assignee manages the sale/liquidation process — not the Board or company officers — which, as a practical matter, tends to insulate the assignee from any potential attack relating to the process or sale terms;

  • Lower admin costs;

  • Lower visibility to an ABC than a bankruptcy filing;

  • Secured creditors general support the process due to its time and cost efficiency, not to mention distribution of proceeds; and

  • Given all of the above, the process should result in higher distributions to general unsecured creditors than, say, a bankruptcy liquidation.

Asleep yet? 😴

Great. Sleep is important. Yes or no, stick with us.

ABCs also have limitations:

  • Secured creditor consent is needed for use of cash collateral.

  • Buyers cannot assume secured debt without the consent of the secured creditor nor is there any possibility for cramdown like there is in chapter 11.

  • There is, generally, no automatic stay. This bit is critical: “While the ABC transfers the assets out of the assignor and therefore post-ABC judgments may have no practical value or impact, litigation can continue against the assignor, and the assignee typically has neither the funding nor the economic motivation to defend the assignor against any litigation. In addition, hostile creditors may decide to shift their focus to other stakeholders (i.e., board members or officers in their capacity as guarantors or fiduciaries) if they believe there will likely be no return for them from the ABC estate.”

  • Assignees have no right to assign executory contracts, diminishing the potential value of market-favorable agreements.

  • No free-and-clear sale orders. Instead you get a “bill of sale.” Choice quote: “A bill of sale, particularly from an assignee who is a well-known and well-regarded fiduciary, is a very powerful document from the perspective of creditor protection, successor liability, etc., but it does not have the same force and effect as a free-and-clear sale order from a bankruptcy court.”

The question right now is, given the robust nature of the capital markets these days, should you care about any of the above? Per Pitchbook:

This is a golden age for venture capital and the startup ecosystem, as illustrated by PitchBook's latest PitchBook NVCA-Venture Monitor. So far this year, $57.5 billion has been invested in US VC-backed companies. That's higher than in six of the past 10 full years and is on pace to surpass $100 billion in deal value for the first time since the dot-com bubble.

Fundraising continues at breakneck speed. Unicorns are no longer rare, and deal value in companies with a $1 billion valuation or more is headed for a new record. The size of VC rounds keeps swelling. Deep-pocketed private equity players are wading in.

Signs of success (or is it excess?) are everywhere you look. On the surface, delivering a resounding verdict that the Silicon Valley startup model not only works, it works well and should be emulated and celebrated.

But what if that's all wrong? What if this is another mere bubble and the VC industry is in fact storing up pain…?

That's the question posited by Martin Kenney and John Zysman—of the University of California, Davis, and the University of California, Berkeley, respectively—in a recent working paper titled "Unicorns, Cheshire Cats, and the New Dilemmas of Entrepreneurial Finance?"

Instead of spending millions, or billions, in the pursuit of unicorns that could emulate the "winner-takes-all" technology platform near-monopolies of Apple and Facebook and the massive capital gains that resulted, VC investors and their LP backers could instead be buying a bunch of fat Cheshire cats. Bloated by overvaluation, and likely to disappear, leaving just a smile and big losses, since many software-focused tech startups have no tangible assets.

They then ask whether there’s more here than meets the eye. More from Pitchbook:

The problem is that this cycle has been marked by easy capital and a fetishization of the early-to-middle parts of the tech startup lifecycle. Lots of incubators and accelerators. "Shark Tank" on television. "Silicon Valley" on HBO. Never before has it been this easy and cheap to start or expand a venture.

Yet on the other end of the lifecycle, exit times have lengthened, as late-series deal sizes swell, reducing the impetus to IPO (in search of public market capital) or sell before growth capital runs out.

So, what’s the problem?

…in the view of Kenney and Zysman, the VC industry lacks discipline, seeking disruption and market share dominance without a clear path to profitability. You see, VC-fueled startups aren't held to the same standard as existing publicly traded competitors who must answer to investors worried about cash flows and operating earnings every three months. Or of past VC cycles where money was tighter, and thus, time to exit shorter.

We’ll come back to the public company standard in a second.

The interesting thing about the private markets becoming the new public markets (with funding galore) is that when the crazy frenzy around funding (PETITION NOTE: read the link) eventually stops, the markets will just be the markets. And all hell will break lose. The question then becomes whether a company has enough liquidity to stem the tide. What happens if it doesn’t?

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An ABC may very well be a viable alternative for dealing with the carnage. But with private markets staying in growth stages privately for longer, doesn’t that likely mean that there’s more viable intellectual property (e.g., software, data, customer lists)? That a company has a bigger and better San Francisco office (read: lease)? That directors have a longer time horizon advising the company (and, gulp, greater liability risk)? Maybe, even, that there’s venture debt on the balance sheet as an accompaniment to the last funding round (after all, Spotify famously had over $1b of venture debt on its balance sheet shortly before going public)?

All of which is to say that “the bigger they come, the harder they fall.” When the music stops — and, no, we will NOT be making any predictions there, but it WILL stop — sure, there will be a boatload of ABCs keeping (mostly West Coast) professionals busy. But there will also be a lot of tech-based bankruptcies of companies that have raised tens of millions of dollars. That have valuable intellectual property. That have a non-residential real property lease that it’ll want to assign in San Francisco’s heated real estate market. That have a potential buyer who wants the comfort of a “free and clear” judicial order. That have shareholders, directors and venture capital funds who will want once-controversial-and-now-very-commonplace third-party releases from potential litigation and a discharge.

Venture capitalists tend to like ABCs for private companies because, as noted above, they’re “lower visibility.” They like to move fast and break things. Until things actually break. Then they move fast to scrub the logos off their websites. What’s worse? Visibility or potential liability?

And then there are the public markets.

A month ago, we discussed Tintri Inc., a California-based flash and hybrid storage system provider, that recently filed for bankruptcy. Therein we cautioned against IPOs of companies with “massive burn rates.” We then went on to highlight the recent IPO of Domo Inc. ($DOMO) and noted it’s significant cash burn and dubious reasons for tapping the public markets, transferring risk to Moms and Pops in the process. The stock was trading at $19.89/share then. Here is where it stands now:

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In the same vein, on Monday, in response to Sunday’s Members’-only piece entitled “😴Mattress Firm's Nightmare😴,” one reader asked what impact a potential Mattress Firmbankruptcy filing could have on Purple Innovation, Inc. ($PRPL), the publicly-traded manufacturer and distributor of Purple bed-in-a-box product. Our response:

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And we forgot to mention rising shipping costs (which the company purports to have mitigated by figuring out…wait for it…how to fold its mattresses).*

And then yesterday, Bloomberg’s Shira Ovide (who is excellent by the way) reported that “Cash Wildfire Spreads Among Young Tech Companies.” She wrote:

It’s time to get real about the financial fragility of young technology companies. Far too many are living beyond their means, flirting with disaster and putting their investors at risk. 

Bloomberg Opinion examined 150 U.S. technology companies that had gone public since the beginning of 2010 and were still operating independently as of Aug. 10. About 37 percent had negative cash from operations in the prior 12 months, meaning their cash costs exceeded the cash their businesses had generated. 

A handful of the companies, including online auto dealer Carvana Co., the mattress e-commerce company Purple Innovation Inc. and health-care software firm NantHealth Inc., were on pace to burn through their cash in less than a year, based on their current pace of cash from operations and reserves in their most recent financial statements.

In addition to Purple Innovation, Ms. Ovide points out that the following companies might have less than 12 months of cash cushion: ShiftPixy Inc. ($PIXY), RumbleON Inc. ($RMBL), RMG Networks Holding Corp. ($RMGN), NantHealth Inc. ($NH), Carvana Co. ($CVNA), and LiveXLive Media Inc. ($LIVX).

She continued:

The big takeaway for me: Young technology companies in aggregate are becoming more brittle during one of the longest bull markets ever for U.S. stocks. This trend is not healthy. Companies that persistently take in less cash than they need to run their businesses risk losing control of their own destinies. They need continual supplies of fresh cash, which could hurt their investors, and the companies may be in a precarious position if they can’t access more capital in the event of deteriorating market or business conditions.

It’s not unusual for young companies, especially fast-growing tech firms, to burn cash as they grow. But the scope of the companies with negative cash from operations, and the persistence of some of those cash-burning companies for years, was a notable finding from the Bloomberg Opinion analysis.

Notable, indeed. There will be tech-based ABCs AND bankruptcies galore in the next cycle. Are you ready? Are you laying the foundation? Are you spending too much time skating to where the puck is rather than where it will be?


*We’ll take this opportunity to state what should be obvious: you should follow us on Twitter.

But, seriously, and more importantly, we know we tout the disruptive effects of the direct-to-consumer model. But make no mistake: we are WELL aware that a number of these upstarts are going to fail. Make no mistake about that.

The Media is Stuck Between a Rock and a Hard Place (Long Recurring Revenue)

Magazines Are Suffering From Declining Ad Revenue

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It’s no secret that traditional advertising is in decline. Now we have some numbers to put around it. Per the WWD:

The magazine industry puts on a brave face, but data doesn’t lie.

New analysis from the Association of Magazine Media, which unabashedly pushed the power of print magazines as an advertising vehicle, shows an industry still trying to find its place in an instantaneous world while advertising revenue continues to slip away.

Reported magazine ad spending by the 50 biggest advertisers last year fell to $6.1 billion from $6.5 billion in 2016, according to AMM’s annual report. So magazines lost at least $417.5 million in revenue last year, a difference of 6.4 percent, numbers AMM did not make readily available in its report, which was sponsored by magazine printer Freeport Press.

The report notes how top advertisers spent their marketing dollars. Pfizer Inc.Johnson & JohnsonLVMH Moet Hennessy Louis VuittonEstee Lauder Cos. Inc.KeringChanel, and Amazon were all WAY down, more than offsetting increases from the likes of Proctor & Gamble and L’Oreal. As just one example, Pfizer’s spend decreased by $85mm. That’s a whopping number.

With whopping ramifications. More from the WWD:

With so much money being lost in print advertising, which is largely being diverted to other avenues, like Facebook, Google and influencers, it’s no wonder magazines keep shutting.

A total of 50 magazines with at least a quarterly publication frequency closed last year, despite 134 titles being launched, leaving the number of magazines last year at 7,176. The number of magazines has been a bit up and down over the last decade, but on the whole, down, as there are 207 fewer than in 2008.

It continued:

Overall, there are very few major magazine brands managing to pull strong through the digital shift. Of the 114 magazine brands tracked by AMM, 56 titles, or 50 percent, have a total audience in decline year-to-date. Print and digital editions are faring even worse, with 74 titles, or 64 percent of magazines, seeing audience on the decline.

Little wonder advertisers are looking elsewhere.

Apropos, a heads up for PETITION readers: you can give the media business a whirl if you masochistically desire. On August 27, the chapter 7 trustee in the case of Interview Inc., the once-famous magazine owned by Peter Brant, is conducting an auction for the sale of the media property. If bankrupted magazines aren’t your jam, there are plenty of other options available — including, most recently, New York Magazine.

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Given the decline in advertising, media companies are re-evaluating their business models and many are toggling over to subscriptions. Subscriptions are the “it” thing now. And that obviously includes PETITION (though, to be accurate, we were never dependent on ads). In fact, we now subscribe to so many different resources that our costs are going up meaningfully from month to month. That’s the truth. At a certain point, consumers may get subscription fatigue.

Or they’ll just share passwords. Per Digiday:

Subscriptions are a great way to draw a steady stream of revenue from readers — unless readers share their login credentials with everyone they know.

As publishers try to grow subscription businesses, they have to figure out how to handle password-sharing, a phenomenon that subscription services like Netflix and Spotify have wrestled with for years.

Netflix and Spotify can absorb this danger. But smaller media outlets either struggling to survive or looking to grow don’t have that luxury. Every time someone shares media that lives off of the subscription model, he/she is effectively siphoning off revenue from them and pushing them one step closer to insolvency. Sadly, only a very select few of you will make fees in that scenario. The rest of you will lose out on quality content you’ve come to love and enjoy. Now wouldn’t that be a shame?

🍟Casual Dining is a Hot Mess. Part IV 🍟

Short Kona Grill ($KONA)

We’ve been all over the casual dining space so much that it’s time to just make this a recurring series. We’ve previously discussed casual dining here (Macro trends, Kona GrillP.F. Ghang China Bistro Inc.Ruby Tuesday and Bertucci’s), here (Applebee’s Neighborhood Grill & Bar) and here (Luby’s Inc. and Steak ‘n Shake).

To continue reading, you must be a PETITION Member. Join here

The Rise of Net-Debt Short Activism (Short Low Default Rates)

Aurelius Goes After Windstream Holdings Inc. 

🤓Another nerd alert: this is about to get technical.🤓

With default rates low, asset prices high, and a system awash with heaps of green, investors are under pressure by LPs and looking for ways to generate returns. They’ll manufacture them if needs be. These forces help explain the recent Hovnanian drama, the recent McClatchey drama and, well, basically anything involving credit default swaps (“CDS”) nowadays. To point, the fine lawyers at Wachtell Lipton Rosen & Katz (“WLRZ”) write:

The market for corporate debt does not immediately lend itself to the same kind of “activism” found in equity markets.  Bondholders, unlike shareholders, do not elect a company’s board or vote on major transactions.  Rather, their relationship with their borrower is governed primarily by contract.  Investors typically buy corporate debt in the hope that, without any action on their part, the company will meet its obligations, including payment in full at maturity.

In recent years, however, we have seen the rise of a new type of debt investor that defies this traditional model.

Right. We sure have. Boredom sure is powerful inspiration. Anyway, WLRZ dubs these investors the “net-short debt activist” investor.

The net-short debt activist investor has a particular modus operandi. First, the investor sniffs around the credit markets trolling for transactions that arguably run afoul of debt document covenants (we pity whomever has this job). Once the investor identifies a potential covenant violation, it scoops up the debt (the “long” position”) while contemporaneously putting on a short position by way of CDS (which collects upon a default). The key, however, is that the latter is a larger position than the former, making the investor “net short.” Relying on its earlier diligence, the investor then publicly declares a covenant default and, if it holds a large enough position (25%+ of the issuance), can serve a formal default notice to boot. The public nature of all of this is critical: the investor knows that the default and/or notice will move markets. And that’s the point: after all, the investor is net short.

In the case of a formal notice, all of this also puts the target in an unenviable position. It now needs to go to court to obtain a ruling that no default has occurred. Absent that, the company is in a world of hurt. WLRK writes:

Unless and until that ruling is obtained, the company faces the risk not only that the activist will be able to accelerate the debt it holds, but also that other financial debt will be subject to cross defaults and that other counterparties of the company — such as other lenders, trade creditors, or potential strategic partners — may hesitate to conduct business with the company until the cloud is lifted.  

Savage. Coercive. Vicious. Long low default rate environments!

In the case of Little Rock Arkansas-based Windstream Holdings Inc. ($WIN), a provider of voice and data network communications services, all of this is especially relevant.

To continue reading, you must be a PETITION Member. Join here

😴Mattress Firm's Nightmare😴

Mattress Firm May File for Bankruptcy (Long Cardboard Box Manufacturers)

 Source: PETITION LLC

Source: PETITION LLC

⚡️Nerd alert: we need to lay a little foundation here.⚡️

For the uninitiated, a First Day Declaration (“FDD”) typically accompanies a chapter 11 petition when a debtor-company files for bankruptcy. The FDD is the first opportunity for a representative of a chapter 11 debtor to sell a particular narrative to the Bankruptcy Judge and other parties in interest; it sets the tone for the company’s “first day hearing,” which is the first formal appearance the company makes in bankruptcy court (typically within 24-48 hours after filing for chapter 11). The FDD is a descriptive document that often spells out the what, why and when of a company’s demise. Nearly all FDDs follow the same format: they (i) provide some color about the declarant, (ii) describe the history and nature of a business, (iii) delineate the capital structure, (iv) outline the events leading to bankruptcy, (iv) articulate the hopes for the bankruptcy case, and (v) summarize the relief sought on the first day. Lawyers often request that the FDD be admitted into the record at the first day hearing (subject to cross examination of the declarant).

Frustratingly, lawyers also often seem compelled to regurgitate the FDD once at the podium at the hearing. This is typically the role of the senior most partner on the matter, i.e., the person who — as it relates to certain firms — probably knows the least about the company, why it’s in bankruptcy and how the hell its going to grind its way out of it. We’re not entirely sure why they feel the need to do this: the judge has presumably read the papers. Perhaps they feel it’s necessary to repeat the narrative to set the tone for the case and establish credibility (more important in controversial cases than in uncontested hearings); perhaps they just like hearing themselves speak; or — the most likely justification — perhaps they bill by the hour and need to justify their (a) existence, (b) exorbitantly high billing rate and/or (c) first billing on the case caption. Maybe it’s all of the above. In any event, this custom is exactly the opposite of what lawyers are taught in law school: be concise and to the point.

We often like to imagine what the FDD would look like in certain situations. Long time PETITION readers may recall our mock FDD for Remington Outdoor Company. Well, we’re at it again. This time for Mattress Firm Holding Corp. Hopefully this will spare the estate some expenses.

To continue reading, you must be a PETITION Member. Join here

💰Goldman Sachs Has its Cake and Eats it Too💰

Short GNC Holdings Inc. Long Care/of. 

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We’ve written extensively hereherehere and here about GNC Holdings Inc. ($GNC) and the challenges that the company faces. We won’t revisit all of that here other than to note that GNC was, upon information and belief, preparing for a bankruptcy filing prior to it amending and extending its term loan, entering into a new ABL, and obtaining $275mm of asset-backed FILO term loans. We quipped that this was the quintessential “kick-the-can-down-the-road” transaction. Goldman Sachs ($GS) advised the company on the entire capital structure fix. Suffice it to say, then, that Goldman Sachs is intimately familiar with the GNC business.

Which, naturally, makes the fact that Goldman Sachs Investment Partners (a division of Goldman Sachs Asset Management) served as the lead investor in vitamin startup Care/of’s Series B financing all the more interesting.

Now, of course, we know Goldman is a big shop. They’re probably talking to WeWorkabout how to design their spaces to balance the sheer volume of “Chinese walls” with the need for an aesthetic that appeals to the millennial mindset. And, surely, Goldman Sachs’ capital advisory arm is entirely different and separate from Goldman’s asset management and venture arm.

But still.

Earlier this week Care/of, a direct-to-consumer wellness brand that specializes in monthly subscriptions of personalized vitamins and supplements, announced the new round of $29mm. In addition to Goldman, investors included Goodwater Capital, Juxtapose, RRE Ventures and Tusk Ventures. Former President of GNC, Beth Kaplan, also invested and will be joining the Board. 🤔

Bloomberg notes:

Care/of, a startup selling vitamins and herbal supplements online, raised funds from investors including Goldman Sachs Group Inc.’s venture arm that value the company at $156 million, within striking distance of publicly traded retail chains that are among the industry’s leaders.

The startup’s $156 million valuation isn’t far from Vitamin Shoppe Inc., with 3,860 employees and a market capitalization of about $203.5 million, or GNC Holdings Inc., which has a market value of $254.2 million with 6,400 employees. Care/of has about 100 workers, Chief Executive Officer Craig Elbert said.

“Consumers are increasingly shifting spend online and so I think large retail footprints have the potential to be a liability,” Elbert said in an interview. “There’s a lot of growth ahead of us and lot of reasons why this should be an e-commerce business.”

This is so Goldman-y. Collect an advisory fee to extend the life of the dominant brick-and-mortar retailer with one hand while investing in a nimble direct-to-consumer upstart that will chip away on that very same retailer on the other hand. Even before the former requires capital markets advice from a Goldman-type in a few years — which, it undoubtedly will — it may be on the lookout for an M&A banker. Perhaps to sell itself. Perhaps to buy a start-up and build a moat against Amazon. How convenient that Goldman will have familiarity with both businesses. We’d say that maybe there’d be a conflict somewhere in there but, well…do those really even exist anymore??

🛋There's Disruption Afoot in the Furniture Space🛋

Add Furniture to the List of Disrupted Categories (Home Heritage Group Inc. Filed for Bankruptcy)

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“New Chapter 11 Filing!” Or is it technically a Chapter 22? 🤔

We know what you’re thinking. You’re thinking “this filed a few days ago and I’ve already read all about it.” You may have read something about it, but not like this. Bear with us…

Home Heritage Group Inc. (“HHG”) is a North Carolina-based designer and manufacturer of home furnishings; it sells product via (i) retail stores, (ii) interior design partners, (iii) multi-line/independent retailers, and (iv) mass merchant stores.” In addition, the company has an international wholesale business.

Why do we mention Chapter 22? For the uninitiated, Chapter 22 in bankruptcy doesn’t actually exist. It is a somewhat snarky term to describe companies that have round-tripped back into chapter 11 after a previous stint in bankruptcy court. That, to some degree, is the case here.

WAAAAAAAY back in November 2013, KPS Capital Partners LP formed the newly bankrupt HHG entity to acquire a brand portfolio and related assets out of the bankruptcy estate of Furniture Brands International Inc. (“FBI”). FBI had been, in the early 2000s, a very successful purveyor of various furniture brands — to the tune of $2b in annual sales. But in the 12 months prior to the acquisition, the company’s sales were down to $940mm and, more importantly, its EBITDA was negative $58mm. At the time of filing, it had $142mm in total funded debt outstanding, $200mm in unfunded pension obligations and another $100mm in general trade obligations.

Given this debt, a decline in sales at the time was devastating. The company noted in its court filings on September 9, 2013 (Docket #16):

As a manufacturer and retail of home furnishings, Furniture Brands’ operations and performance depend significantly on economic conditions, particularly in the United States, and their impact on levels of existing home sales, new home construction, and consumer discretionary spending. Economic conditions deteriorated significantly in the United States and worldwide in recent years as part of a global financial crisis. Although the general economy has begun to recover, sales of residential furniture remain depressed due to wavering consumer confidence and several, ongoing global economic factors that have negatively impacted consumers’ discretionary spending. These ongoing factors include lower home values, prolonged foreclosure activity throughout the country, a weak market for home sales, continued high levels of unemployment, and reduced access to consumer credit. These conditions have resulted in a decline in Furniture Brands’ sales, earnings and liquidity.

Sales have continued to be depressed as a result of a sluggish recovery in the U.S. economy, continuing high unemployment, depressed housing prices, tight consumer lending practices, the reluctance of some households to use available credit for big ticket purchases including furniture, and continuing volatility in the retail market.

PETITION Note: My, how things have changed. Just reflect on that synopsis of the economy a mere five years ago. The company also noted that:

…some of the Company’s larger brands have lost some of their market share primarily due to competition from suppliers who are able to produce similar products at lower costs. The residential furniture industry is highly competitive and fragmented. Furniture Brands competes with many other manufacturers and retailers, some of which offer widely advertised, well-known, branded products, and other competitors are large retail furniture dealers who offer their own store-branded products.

All of these factors stormed together to constrain the company’s liquidity and force a chapter 11 filing and eventual sale. KPS purchased several of the FBI brands for $280mm (subject to working capital adjustments), including Thomasville, Broyhill, Lane, Drexel Heritage, Henredon, Pearson, Hickory Chair, Lane Venture, and Maitland-Smith. In other words: brands that your grandfather would know and you would shrug at the mere mention of. Well, some of you anyway.

Fast forward five years and the successor entity HHG has $280mm of debt and…you guessed it…severe liquidity constraints. In its first day filing papers, HHG notes that the previous bankruptcy continues to have lasting effects on its business; it highlights:

Following years of sales declines, many furniture retailers had lost faith in the ability of the Company to produce, deliver, and service its products, and the bankruptcy led many of them to shift their purchases to a variety of competitors or even further utilize their own private label offerings.

This is what people still nostalgically refer to as “bankruptcy stigma.” Indeed, it still exists. The company continued:

In addition, the Company’s operations and performance depend significantly on economic conditions, particularly in the United States, and their impact on levels of existing home sales, new home construction, and consumer discretionary spending. Although economic conditions have been steadily improving in recent years, the Debtors have struggled to adjust to certain shifts in consumer lifestyles, which include: (i) lower home-ownership levels and more people renting; (ii) more apartment living and single-person households; (iii) older consumers that want to age in place; and (iv) cash-strapped millennials that are slow in forming households relative to prior generations.

Haha! The poor millennials. Apparently an entire generation is “cash-strapped” and prefers to sleep in a tent under their WeWork desks. Blame the avocado toast and turmeric lattes. But, wait, there’s more:

Consumer browsing and buying practices are rapidly shifting as well toward greater use of social media, internet- and app-based catalogs and e-commerce platforms, and the Company has been unable to develop a substantial sales base for its brands through this key growth channel.

Furthermore, the residential furniture industry is highly competitive and fragmented. The Company competes with many other manufacturers and retailers, some of which offer widely advertised, well-known, branded products, and other competitors are large retail furniture dealers who offer their own private label products. This competitive landscape has proved challenging for some of the Company’s larger brands as well-capitalized competitors continue to gain market share at the expense of the Debtors. (emphasis added)

PETITION Note: My, how things have remained the same. Sound familiar? Have to hand it to the professionals here: why reinvent the wheel when you can just crib from the prior filing? We guess being a repeat customer in bankruptcy has its benefits!! Chapter 22!!!

<p>Meanwhile a short digression relevant to those last two quoted paragraphs. According to Statistaworldwide online furniture and homewares sales are expected to be close to $190 billion. Take a look at this chart:

RetailDive notes:

E-commerce furniture sales have emerged as a major growth area, rising 18% in 2015, second only to grocery, according to research from Barclays.

Accordingly, GartnerL2 cautions that:

…home brands now have an outsized onus to produce best-in-class product pages for the influx of online shoppers. However, many brands have failed to deliver and aren’t keeping pace with industry disruptors.

Sounds like HHG has, admittedly, fallen into this category.

GartnerL2 highlights the disparate user experiences offered by Williams-Sonoma-owned West Elm and Chicago-based DTC disruptor Interior Define, which was founded in 2013 and has raised $27mm in funding (most recently a Series B in March). The latter offers extensive imagery, a visual guide and an augmented reality mobile app. All of these things appeal to the more-tech-savvy (non-cash-strapped??) millennial buyer.

And that is precisely the demographic that La-Z-Boy Incorporated ($LZB) is going after with its purchase of Joybird, a California-based direct-to-consumer e-commerce retailer and manufacturer of upholstered furniture. Founded in 2014, its $55mm in reported revenue last year took a chunk out of, well, someone. Other players in that space include Burrow ($19.2mm in total funding; most recent Series A in March from New Enterprise Associates) and, of course, Amazon’s in-house furniture brandsRivet and Stone & Beam. <p><end>

All of these factors resulted in continual YOY declines in sales and a liquidity squeeze. Now, therefore, the company is in bankruptcy to effectuate a sale — or sales — of its brands to prospective bidders. It has one purchaser in line for the “Luxury Group” and, according to the court filing, appears close to an agreement with a stalking horse buyer of the Broyhill and Thomasville & Co. properties. In the meantime, the company has a commitment from prepetition lender PNC Bank NA for a $98mm DIP, of which $25mm Judge Gross granted on an interim basis.

⚡️Is PG&E in Trouble?⚡️

PG&E Reported Earnings (Long Climate Change)

Long time PETITION readers know that our general theme is “disruption, from the vantage point of the disrupted.” Disruption can come in various forms. In many cases it comes from technological innovation. The dreaded “Amazon Effect” that everyone is so tired of hearing about falls into this category. But as we’ve said time and time again, mobile e-commerce is a big part of that story and that would never have been made possible — and perhaps brick-and-mortar would still be intact — if it weren’t for the Apple Iphone ($AAPL), for Shopify ($SHOP), and for Instagram ($FB), among many other disrupters. Today’s innovations are leading indicators for tomorrow’s bankruptcies.

Disruption — and, no, we don’t always use this term in the Clayton Christensen sense — can come in other forms. There can be regulatory and/or legislative disruption, political disruption, environmental disruption, etc. In the case of PG&E — short for Pacific Gas and Electric Company — it may be all of the above.

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