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.
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’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.
On Valentine’s Day, in “Misplaced Optimism in Retail: L Brands - What the Holy F*#*?,” we clowned on Leslie Wexner’s aggressive approach to retail and said “tell us that you don’t want to short the sh*t out of the stock.” It was trading at $49.87/share. Now...
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We have spoken a lot about direct-to-consumer digitally native brands having a tremendous — and understated (in restructuring circles) — affect on brick-and-mortar retail. Apparel in particular. PETITION readers are already familiar with Wish, a unicorn shopping platform with a valuation north of $8 billion. It’s secret sauce is allowing consumers to purchase clothes directly from Chinese factories. Imagine all of the middlemen cut out of that equation. No “brand tax” either.
Earlier this week Sequoia Capital China led an investment in Jollychic, a China-based e-commerce startup that lets Middle Eastern shoppers order unbranded products from Chinese factories.
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Subscription-based razors? Check. Subscription-based contact lenses? Check. Now the direct-to-consumer digitally-native-vertical-brand world is coming for your teeth. Direct to consumer teeth alignment? Check. Subscription-based dental floss? Check. Subscription-based bluetooth compatible toothbrushes. Check. No. This is not a joke.
The Rise of the Electric Scooter
Do y’all remember the segway? It was supposed to revolutionize transportation but it never took off as anything more than the butt of a joke. Why? Look at the above photo. Homeboy can pump as many curls as he needs to but all the bulging biceps in the world won’t make him look bada$$ riding one of those things. Plus, watch the eye level broheim.
Anyway, there is a new mode of transportation that is all the rage. Introducing the dockless electric scooter…
Use of Proceeds? Pay Back Dividend Recap Incurred Debt
CVC and Leonard Green & Partners have filed for a $100 million IPO of portfolio company, BJ’s Wholesale Club Holdings Inc. With Costco ($COST) killing it of late and the IPO marking champing at the bit for more new issues, this reeks of (sound capitalistic) opportunism. BJ’s has 215 locations nation-wide; it generated net income of $50 million on total sales of $12.8 billion for fiscal 2017. The company highlights that new implementations "delivered results rapidly, evidenced by positive and accelerating comparable club sales over the last two quarters and net income growth of over 109% and Adjusted EBITDA growth of 31% in aggregate over the last two fiscal years."
The BJ’s story is an interesting one for private equity. Take a look at these numbers from the company’s S-1 filing:
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In recent years, ABI Presidents have pursued lengthy agendas, including the ABI Chapter 11 Commission, launching an ethics task force, and creating the Consumer Bankruptcy Commission – all worthy projects deserving our respect. I have a tough act to follow as the incoming president.
Last month, I was pleased to announce the formation of the ABI Task Force on Veterans Affairs. Led by members and U.S. veterans John Ames, John Penn and Jack Williams, the group is comprised of individuals who are committed to changing veterans’ lives in a meaningful way. The Task Force will examine how the bankruptcy system treats veterans differently, and unfortunately— less favorably. Recommendations and corrective steps will be proposed to Congress or the Rules Committee in the coming year to improve bankruptcy outcomes for all veterans.
Consider what it’s like for vets to return home with any one of the many issues our brave warriors experience after serving their country. And then add to that the financial burden imposed by their service— a burden exacerbated by the cost of transitioning to civilian life; the medical fees associated with caring for injuries; transportation expense to healthcare professionals located at inconveniently-located VA hospitals; and lost income each time they have to see a VA doctor.
Then imagine as the crushing burden of medical or consumer debt mounts, you may be treated in an unfavorable way under the current Bankruptcy Code— especially if you’re a disabled vet.
When a civilian qualifies for and receives social security disability payments, those payments are based on their past income, and in the event of a bankruptcy filing, are not counted as income under the means test. When a disabled veteran files a bankruptcy petition, their disability payments are counted as income under the means test. The effect of this disparity is that someone on veteran disability has a lower likelihood of being able to avail themselves of the complete discharge offered by chapter 7 than a debtor who receives social security disability payments. This is but one of the ways in which the Code fails to work for veterans and service members.
I look at this problem, and I am reminded that ABI’s membership has shown, time and time again, that when its talents are utilized and focused, we can literally redefine our field. And I ask, what solutions to this problem might be unlocked by the brainpower of our members? I know that we haven’t done enough to change the things we can for veterans.
For an organization that many associate with corporate mega-bankruptcies, we’ve achieved quite a lot to improve outcomes for individuals whose lives are impacted by bankruptcies – either their own, their employer’s, or the companies they have built that have fallen on hard times. And now, we’re going to make bankruptcy function better for those who have served our country.
Moody's, Fitch & Guggenheim Partners Chime In
Earlier this week, Moody’s Default and Ratings Analytics team forecasted that the US’ trailing 12-month high-yield default rate will sink to 2% — from its February 2018 3.6% level — by February 2019. That is not a good sign for restructuring professionals itching for an uptick in activity.
FitchRatings chimed in as well, noting that underwriting standards underscore that the leveraged debt market is in the later stages of the credit cycle. But, it added,
“Aggressive documentation terms now prevalent could challenge recoveries in the next downturn. However, a surge in refinancing activity since 2016 should increase time between the credit cycle's bottom and peak in default rates. Looser documentation, such as the prevalence of covenant-lite (cov-lite) loans, should also lower the risk of technical default while enabling issuers to access additional funding via secured debt and unrestricted subsidiary provisions.” (emphasis ours)
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Another Shoe Retailer Strolls into Bankruptcy Court
A few weeks back, we wrote this in “👞UGGs & E-Comm Trample Birkenstock👞,”
“Mere days away from a Nine West bankruptcy filing, we can’t help but to think about how quickly the retail landscape is changing and the impact of brands. Why? Presumably, Nine West will file, close the majority of - if not all of - its brick-and-mortar stores and transfer its brand IP to its creditors (or a new buyer). For whatever its brand is worth. We suppose the company’s lenders - likely to receive the company’s IP in a debt-for-equity swap, will soon find out. We suspect ‘not a hell of a whole lot’.”
Now we know: $123 million. (Frankly more than we expected.)
Consistent with the micro-brands discussion above, we also wrote,
“Saving the most relevant to Nine West for last,
Sales at U.S. shoe stores in February 2017 fell 5.2%, the biggest year-over-year tumble since 2009. Online-only players like Allbirds, Jack Erwin, and M.Gemi have gained nearly 15 percentage points of share over five years.
Yes, the very same Allbirds that is so popular that it is apparently creating wool shortages. Query whether this factor will be featured in Nine West’s First Day Declaration with such specificity. Likely not.”
Now we know this too: definitely not.
But Nine West Holdings Inc., the well-known footwear retailer, has, indeed, finally filed for bankruptcy. The company will sell the intellectual property and working capital behind its Nine West and Bandolino brands to Authentic Brands Group for approximately $200 million (inclusive of the above-stated $123 million allocation to IP, subject to adjustment) and reorganize around its One Jeanswear Group, The Jewelry Group, the Kasper Group, and Anne Klein business segments. The company has a restructuring support agreement (“RSA”) in hand with 78% of its secured term lenders and 89% of its unsecured term loan lenders to support this dual-process. The upshot of the RSA is that the holders of the $300 million unsecured term loan facility will own the equity in the reorganized entity focused on the above-stated four brands. The case will be funded by a $247.5 DIP ABL which will take out the prepetition facility and a $50mm new money dual-draw term loan funded by the commitment parties under the RSA (which helps justify the equity they’ll get).
Regarding the cause for filing, the company notes the following:
“The unprecedented systemic economic headwinds affecting many brick-and-mortar retailers (including certain of the Debtors’ largest customers) have significantly and adversely impacted the operating performance of the Debtors’ footwear and handbag businesses over the past four years. The Nine West Group (and, prior to its sale, Easy Spirit®), the more global business, faced strong headwinds as the macro retail environment in Asia, the Middle East, and South America became challenged. This was compounded by a difficult department store environment in the United States and the Debtors’ operation of their own unprofitable retail network. The Debtors also faced the specific challenge of addressing issues within their footwear and handbag business, including product quality problems, lack of fashion-forward products, and design missteps. Although the Debtors implemented changes to address these issues, and have shown significant progress over the past several years, the lengthy development cycle and the nature of the business did not allow the time for their operating performance within footwear and handbags to improve.”
Regarding the afore-mentioned “macro trends,” the company further highlights,
“…a general shift away from brick-and-mortar shopping, a shift in consumer demographics away from branded apparel, and changing fashion and style trends. Because a substantial portion of the Debtors’ profits derive from wholesale distribution, the Debtors have been hurt by the decline of many large retailers, such as Sears, Bon-Ton, and Macy’s, which have closed stores across the country and purchased less product for their stores due to decreased consumer traffic. In 2015 and 2016, the Debtors experienced a steep and unanticipated cut back on orders from two of the Debtors’ most significant footwear customers, which led to year over year decreases in revenue of $16 million and $46 million in 2015 and 2016, respectively. These troubles have been somewhat offset by e-commerce platforms such as Amazon and Zappos, but such platforms have not made up for the sales volume lost as a result of brick-and-mortar retail declines.”
No Allbirds mention. Oh well.
But wait! Is that a POSITIVE mention of Amazon ($AMZN) in a chapter 11 filing? We’re perplexed. Seriously, though, that paragraph demonstrates the ripple effect that is cascading throughout the retail industrial complex as we speak. And it’s frightening, actually.
On a positive note, The One Jeanswear Group, The Jewelry Group, the Kasper Group, and Anne Klein business segments, however, have been able to “combat the macro retail challenges” — just not enough to offset the negative operating performance of the other two segments. Hence the bifurcated course here: one part sale, one part reorganization.
But this is the other (cough: real) reason for bankruptcy:
Soooooo, yes, don’t tell the gentlemen mentioned in the Law360 story but this is VERY MUCH another trite private equity story. 💤💤 With $1.6 billion of debt saddled on the company after Sycamore Partners Management LP took it private in 2014, the company simply couldn’t make due with its $1.6 billion in net revenue in 2017. Annual interest expense is $113.9 million compared to $88.1 million of adjusted EBITDA in fiscal year 2017. Riiiiight.
A few other observations:
Leases. The company is rejecting 75 leases, 72 of which were brick-and-mortar locations that have already been abandoned and turned over to landlords. Notably, Simon Property Group ($SPG) is the landlord for approximately 35 of those locations. But don’t sweat it: they’re doing just fine.
Liberal Definitions. As Interim CEO, the Alvarez & Marsal LLC Managing Director tasked with this assignment has given whole new meaning to the word “interim.” Per Dictionary.com, the word means “for, during, belonging to, or connected with an intervening period of time; temporary; provisional.” Well, he’s been on this assignment for three years — nearly two as the “interim” CEO. Not particularly “temporary” from our vantage point. P.S. What a hot mess.
Chinese Manufacturing. Putting aside China tariffs for a brief moment, if you're an aspiring shoe brand in search of manufacturing in China and don't know where to start you might want to take a look at the Chapter 11 petitions for both Payless Shoesource and Nine West. A total cheat sheet.
Chinese Manufacturing Part II. If President Trump really wants to flick off China, perhaps he should reconsider his (de minimus) carried interest restrictions and let US private equity firms continue to run rampant all over the shoe industry. If the recent track record is any indication, that will lead to significantly over-levered balance sheets borne out of leveraged buyouts, inevitable bankruptcy, and a top 50 creditor list chock full of Chinese manufacturing firms. Behind $1.6 billion of debt and with a mere $200 million of sale proceeds, there’s no shot in hell they’d see much recovery on their receivables and BOOM! Trade deficit minimized!!
Yield Baby Yield! (Credit Market Commentary). Sycamore’s $120 million equity infusion was $280 million less than the original binding equity commitment Sycamore made in late 2013. Why the reduction? Apparently investors were clamoring so hard for yield, that the company issued more debt to satisfy investor appetite rather than take a larger equity check. Something tells us this is a theme you’ll be reading a lot about in the next three years.
Athleisure & Casual Shoes. The fleeting athleisure trend took quite a bite out of Nine West’s revenue from 2014 to 2016 — $36 million, to be exact. Jeans, however, are apparently making a comeback. Meanwhile, the trend towards casual shoes and away from pumps and other Nine West specialties, also took a big bite out of revenue. Enter casual shoe brand, GREATS, which, like Allbirds, is now opening a store in New York City too. Out with the old, in with the new.
Sycamore Partners & Transparency in Bankruptcy. Callback to this effusive Wall Street Journal piece about the private equity firm: it was published just a few weeks ago. Reconcile it with this statement from the company, “After several years of declines in the Nine West Group business, part of the investment hypothesis behind the 2014 Transaction was that the Nine West® brand could be grown and strong earnings would result.” But “Nine West Group net sales have declined 36.9 percent since fiscal year 2015—from approximately $647.1 million to approximately $408 million in the most recent fiscal year.” This is where bankruptcy can be truly frustrating. In Payless Shoesource, there was considerable drama relating to dividend recapitalizations that the private equity sponsors — Golden Gate Capital Inc. and Blum Capital Advisors — benefited from prior to the company’s bankruptcy. The lawsuit and accompanying expert report against those shops, however, were filed under seal, keeping the public blind as to the tomfoolery that private equity shops undertake in pursuit of an “investment hypothesis.” Here, it appears that Sycamore gave up after two years of declining performance. In the company’s words, “Thus, by late 2016 the Debtors were at a crossroads: they could either make a substantial investment in the Nine West Group business in an effort to turn around declining sales or they could divest from the footwear and handbag business and focus on their historically strong, stable, and profitable business lines.” But don’t worry: of course Sycamore is covered by a proposed release of liability. Classic.
Authentic Brands Group. Authentic Brands Group, the prospective buyer of Nine West's IP in bankruptcy, is familiar with distressed brands; it is the proud owner of the Aeropostale and Fredericks of Hollywood brands, two prior bankrupt retailers. Authentic Brands Group is led by a the former CEO of Hilco Consumer Capital Corp and is owned by Leonard Green & Partners. The proposed transaction means that Nine West's brand would be transferred from one private equity firm to another. Kirkland & Ellis LLP represented and defended Sycamore Partners in the Aeropostale case as Weil Gotshal & Manges LLP & the company tried to go after the private equity firm for equitable subordination, among other causes of action. Kirkland prevailed. Leonard Green & Partners portfolio includes David's Bridal, J.Crew, Tourneau and Signet Jewelers (which has an absolutely brutal 1-year chart). On the flip side, it also owns (or owned) a piece of Shake Shack, Soulcycle, and BJ's. The point being that the influence of the private equity firm is pervasive. Not a bad thing. Just saying. Today, more than ever, it seems people should know whose pockets their money is going in to.
Official Committee of Unsecured Creditors. It’ll be busy going after Sycamore for the 2014 spin-off of Stuart Weitzman®, Kurt Geiger®, and the Jones Apparel Group (which included both the Jones New York® and Kasper® brands) to an affiliated entity for $600 million in cash. Query whether, aside from this transaction, Sycamore also took out management fees and/or dividends more than the initial $120 million equity contribution it made at the time of the transaction. Query, also, whether Weil Gotshal & Manges LLP will be pitching the committee to try and take a second bite at the apple. See #8 above. 🤔🤔
Timing. The company is proposing to have this case out of bankruptcy in five months.
This will be a fun five months.
Resale and Micro-Brands Are a Big Piece of the Retail Disruption Story
Let’s start with this SHAMELESS Law360 piece (paywall) which doubles as a promotional puff piece on behalf of the private equity industry. Therein a number of conflicted professionals go on record to say that private equity has taken far too much flack for the demise of retail. The piece is pure comedy…
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