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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💰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.

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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.

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.

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💰Goldman Sachs Has its Cake and Eats it Too💰

Short GNC Holdings Inc. Long Care/of. 

Wolf of Wall Street.gif

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??

⚡️Important Toys R Us Update⚡️

Late last night Toys R Us filed a motion seeking approval of a “global settlement” in its chapter 11 cases. A consensual deal to move the cases forward in a way that maximizes what remains of the estate — without the value leakage that would result from protracted litigation — is undoubtedly a good thing for all parties in interest.

Still, we’d be remiss if we didn’t note the following considering recent noise in the market:

 Source: Settlement Motion, 7/17/18

Source: Settlement Motion, 7/17/18

Ah, the sacrifices.

💥KKR Effectively Tells Bernie Sanders to Pound Sand💥

Toys R Us (Short Severance Payments)

Toys R Us (Short Severance Payments). Ok, this is getting out of hand. Shortly after Dan Primack wrote that KKR ought to pay for 30,000 employees’ severance OUT OF THE GOODNESS OF KKR’S HEART, Pitchbook jumped in parroting the same nonsense.

Look. Don’t get us wrong. Long time readers know that we’ve been hyper-critical of the PE bros since our inception. But this is just ludicrous already. In “💩Will KKR Pay Toys' Severance?💩” and again in “🔥Amazon is a Beast🔥 we noted that “[t]here’s ZERO CHANCE IN HELL KKR funds severance payments.” We stand by that. Without any legal compunction to do so, these guys aren’t going to just open up their coffers to dole out alms to the affected. That’s not maximizing shareholder value. Those affected aren’t exactly future LPs.

But wait. This keeps getting better.

On Friday, The Wall Street Journal reported that on July 5:

Nineteen members of Congress sent a letter to the private-equity backers of Toys “R” Us Inc. questioning their role in the toy retailer’s bankruptcy and criticizing the leveraged-buyout model as an engine of business failure and job loss.

The letter’s content? Per the WSJ:

It asks whether the investment firms deliberately pushed Toys “R” Us into bankruptcy and encourages them to compensate the roughly 33,000 workers who lost their jobs.

Take a look at this letter. It demonstrates an utter lack of understanding of how private equity works.

Meanwhile, Congress cannot get the President of the United States to turn over his tax returns with the entire country waiting for that to happen and yet we’re supposed to believe that a letter will compel KKR to make severance payments. Utterly laughable. KKR owns those fools and they know it. Okay: maybe not Bernie Sanders.

Imagine the response:

“Um, yes, Representative Poindexter. We did. We deliberately flushed hundreds of millions of dollars of equity checks down the toilet. We hear that makes a compelling marketing message to potential LPs of our next big fund.”

Thankfully, you don’t have to imagine the response because KKR already responded. Per the WSJ:

KKR issued a response dated July 6 stating that Toys “R” Us’s troubles were caused by market forces—specifically the growth of e-commerce retailers—and that the decision to liquidate was made by the company’s creditors, not KKR, and was against the firm’s wishes.

Furthermore:

KKR stated in its response that it reinvested $3.5 billion in Toys “R” Us over the course of its ownership and didn’t take any investment profits. It added that it wrote down its entire equity investment of $418 million and challenged reports that it had earned a profit on the investment.

“Even accounting for fees received from Toys ‘R’ Us, we have lost many millions of dollars. To find anyone who profited, one would need to look at the institutions that pushed for Toys to liquidate its U.S. business,” the firm wrote.

In other words: “Pound sand, Sanders.”

Bubbles (Short Prognisticators…Nobody Effing Knows)

This Morgan Housel piece talks about the psychology of bubbles. Good investors understand fundamentals but also have a sense for which direction the wind is blowing. This bit resonated:

Lehman Brothers was in great shape on September 10th, 2008. That’s what the statistics said, anyway.

Its Tier 1 capital ratio – a measure a bank’s ability to endure loss – was 11.7%. That was higher than the previous quarter. Higher than Goldman Sachs. Higher than Bank of America. Higher than Wells Fargo. It was more capital than Lehman had in 2007, when the banking industry and economy were about the strongest they had ever been.

Four days later, Lehman was bankrupt.

The most important metric to Lehman during this time was confidence and trust among short-term bond lenders who fed its balance sheet with capital. That was also one of the hardest things to quantify.

💩Will KKR Pay Toys' Severance? Part II. 💩

On Wednesday we bashed Dan Primack’s notion that KKR would fund Toys R Us’ severance payments. Apparently we weren’t the only ones. Primack subsequently wrote:

 Equity share: In writing about Toys "R" Us on Tuesday, I mentioned that private equity firms have an obligation to portfolio company employees. Some readers pushed back via email, but it's worth noting that Toys backer KKR has been providing equity to some of its portfolio companies (including Gardner Denver, CHI Overhead Doors and Capsugel).

  • Obviously it's not apples-to-apples with Toys, but such equity-share does reflect a more modern private equity mentality toward portfolio company employees. Bloomberg wrote about the Gardner Denver example last year.

There’s ZERO CHANCE IN HELL KKR funds severance payments. Just stop Dan. If we’re wrong, we’ll gladly eat this.

🚗Where’s the Auto Distress? Part II (#MAGA!!)🚗

In “🚗Where's the Auto Distress?🚗,” we poked fun at ourselves and our earlier piece entitled “Is Another Wave of Auto-Related Bankruptcy Around the Corner?” because the answer to the latter has, for the most part, been “no.” But both pieces are worth revisiting. In the latter we wrote,

Production levels, generally, are projected to decline through 2021. Obviously, reduced production levels and idled plants portend poorly for a lot of players in the auto supply chain. 

And in the former we noted,

So, sure. Distressed activity thus far in 2018 has been light in the automotive space. But dark clouds are forming. Act accordingly.

And by dark clouds, we didn’t exactly mean this but:

Screen Shot 2018-07-01 at 10.11.21 AM.png

With a seeming snap-of-the-finger, Harley Davidson ($HOG) announced that it would move some production out of the US to Europe, where HOG generates 16% of its sales, to avoid EU tariffs on imported product. Per the Economist:

It puts the cost of absorbing the EU’s tariffs up to the end of this year at $30m-45m. It has facilities in countries unaffected by European tariffs that can ramp up relatively quickly.

Trump was predictably nonplussed, saying “don’t get cute with us” and this:

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AND this:

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More from the Economist:

AMERICAN companies “will react and they will put pressure on the American administration to say, ‘Hey, hold on a minute. This is not good for the American economy.’” So said Cecilia Malmström, the European Union’s trade commissioner, on news that Harley-Davidson plans to move some production out of America to avoid tariffs imposed by the EU on motorcycles imported from America.

Will react? Harley Davidson has reacted. Likewise, motorcycle-maker Polaris Industries Inc. ($PII) indicated Friday that it, too, is considering moving production of some motorcycles to Poland from Iowa on account of the tariffs. Per the USAToday:

In its first quarter earnings released in April, Polaris projected around $15 million in additional costs in 2018. Rogers said the latest tariffs would raise costs further, declining to estimate by how much. "But we're definitely seeing an increase in costs," she said.

General Motors Co. ($GM) also weighed in. Per Reuters:

The largest U.S. automaker said in comments filed on Friday with the U.S. Commerce Department that overly broad tariffs could "lead to a smaller GM, a reduced presence at home and abroad for this iconic American company, and risk less — not more — U.S. jobs."

Zerohedge noted:

The Auto Alliance industry group seized on the figure, arguing that auto tariffs could increase the average car price by nearly $6,000, costing the American people an additional $45 billion in aggregate.

Moody’s weighed in as well:

US auto tariff would be broadly credit negative for global auto industry. Potential US tariffs on imported cars, parts are broadly credit negative for the auto industry. The Commerce Department is conducting a review of whether auto imports harm national security. A similar probe resulted in 25% tariffs on imported steel and 10% on aluminum being implemented 1 June. A 25% tariff on imported vehicles and parts would be negative for most every auto sector group – carmakers, parts suppliers, dealers, retailers and transportation companies.

Relating specifically to Ford Motor Company ($F) and GM, it continued further:

US automakers would be negatively affected. Tariffs would be a negative for both Ford and GM. The burden would be greater for GM because it depends more on imports from Mexico and Canada to support US operations – 30% of its US unit sales versus 20% of US sales for Ford. In addition, a significant portion of GM's high-margin trucks and SUVs are sourced from Mexico and Canada. In contrast, Ford's imports to the US are almost exclusively cars — a franchise it is winding down. Both manufacturers would need to absorb the cost of scaling back Mexican and Canadian production and moving some back to the US. They would also probably need to subsidize sales to offset the tariffs for a time, with higher costs eventually passed on to consumers.

On the supply side, Moody’s continued:

Tariffs would also hurt major auto-parts manufacturers. The largest parts suppliers match automakers' production and vehicles and may struggle to adapt following any tariffs. Suppliers' efforts to keep cost down often result in multiple cross-border trips for goods and could incur multiple tariff charges. Avoiding those costs may disrupt the supply chain. Some parts makers have US capacity they could restart at a price. Companies with broad product portfolios, large market share, or that are sole suppliers of key parts will fare better.

And what about dealers and parts retailers? More from Moody’s:

Significant negative for US auto dealers, little change for parts retailers. Dealers heavily weighted toward imports (most of those we rate) will suffer. Penske Auto and Lithia would fare best. Many brands viewed as imports, such as BMW and Toyota, are assembled in the US, so there could be model shifting. Tariffs would be fairly benign for part retailers insulated by demand from the 260 million vehicles now on the road.

Upshot: perhaps its too early to give up on our predictions. Thanks to President Trump’s trade policy, there may, indeed, be auto distress right around the corner as big players adjust their supply chain and manufacturing models. Revenue streams are about to be disrupted.

Is Brookstone Headed for Chapter 22?

Go to Brookstone’s website for “Gift Ideas” and “Cool Gadgets” and then tell us you have any doubt. We especially liked the pop-up asking us to sign up for promotional materials one second after landing; we didn’t even get a chance to see what the company sells before it was selling us on a flooded email inbox. Someone please hire them a designer.

On Friday, Reuters reported that...

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💩Will KKR Pay Toys R Us' Severance?💩

Optimism Remains in Toys R Us Situation

Surprisingly.

You’d think that every person on the planet would be sufficiently jaded by anything Toys R Us at this point. Apparently not everyone. And, oddly, the optimism seems to come from someone typically critical/skeptical of private equity…

Yesterday Axios’ Dan Primack’s lead piece asked, “Should the former private equity owners of Toys "R" Us pay around $70 million in severance to the company's 33,000 laid-off employees?” The question seems to stem from reports that limited partners (i.e., pension funds) are questioning what took place with the Toys investment. We noted this on Sunday:

🔥Elsewhere in private equity, maybe there’ll be backlash emanating out of Toys R Us?? The Minnesota State Board of Investment voted to halt investments in KKR pending a review of the bigbox toy retailer. 🔥

With this as background, Primack wrote:

This is not an academic question. It's become the subject of some public pension investment committee meetings, prompted by a lobbying campaign by left-leaning nonprofit advocacy groups, and has gotten the private equity industry's attention.

  • The basic argument: Bain Capital, KKR and Vornado killed Toys "R" Us by saddling it with too much debt, while taking out fees along the way. It's only fair that they help folks who are without work because of private equity's mismanagement, particularly when PE firms are so rich and many of the employees were living paycheck-to-paycheck.

  • The legal argument: There is none. The private equity firms no longer own Toys "R" Us, and a bankruptcy court judge threw out the severance package because employees weren't high enough in the creditor stack.

We’re old enough to remember when mass shootings got private equity’s attention too. They promised to divest. They didn’t. And then Vegas happened. And then Florida happened. And then Bank of America ($BAC) swore off lending to gun companies only to, uh, lend to Remington Outdoor Company.

We’re old enough to remember people like Warren Buffett say that they should pay more in taxes. That his secretary has a higher effective tax rate than he does. But, to our knowledge, he didn’t exactly voluntarily write a billion dollar check to the U.S. Treasury.

Likewise, neither will KKR write a severance check to employees. No frikken way in hell. Why? Because there is no compulsion to do so. The legal argument? He’s right, “[t]here is none.” So, yeah, good luck with that.

And so the above is really where the piece should stop. A nice little moral high ground piece about how employees and vendors got effed, it is what is, now on to tariffs, Petsmart’s asset stripping “mystery,” Harley Davidson’s ($HOG) war with President Trump or Moviepass owner Helios & Matheson’s ($HMNY) stock hitting a record low.

But Primack also points out,

Finally, the pro-severance folks are a bit liberal (no pun intended) with their math. They argue the PE firms took out $464 million, by adding up advisory fees ($185m), expenses ($8m), transaction fees ($128m) and interest on debt held by the sponsors ($143m). Yes, we were first to point out how the general partners may have gotten back more than they put in. But some of those fees were shared with LPs — including the now-aghast public pensions — while the interest was held in CLOs that had their own investors. In other words, PE "profit" was much smaller than claimed (although, on the flip side, you could argue the firms collected management fees on Toys-related capital that ended up being set on fire... again, it's complicated). (emphasis added)

Right. We’re sure the Minnesota State Board of Investment is cutting a check as we speak.

Sadly Primack didn’t stop there; he continued,

PE firms do have moral obligations to portfolio company employees. You break it, you own it (even if you technically broke it while owning it, which caused someone else to own it).

Um, ok, sure.

He continues,

Bottom line: The PE firms should pay at least some of the severance, or figure out some other form of compensation. And I have a sense that they might. Not because of preening public pension staffers or legal obligations, but because it's the right thing to do. Sometimes it's just that simple.

LOL. Riiiiiiight. In the absence of Mr. Primack having an inside track at KKR, it’s just that fantastic (def = “imaginative or fanciful; remote from reality.”).

What to Make of the Credit Cycle. Part 8. (Long Yield, Baby. Yield)

A. M&A is En Fuego

PwC released an analysis of M&A activity. In summary:

The number of deals north of $5 billion is on pace to double last year’s total, and to date has driven overall deal value up by more than 50%, according to a PwC analysis of Thomson Reuters data. Deals are also getting bigger, with more announced deals of at least $30 billion so far in 2018 than in all of 2017.

Since the start of 2018, one-third of megadeals crossed sector lines, driven largely by an appetite for new technologies. That interest in tech hasn’t been limited to huge transactions, with examples of smaller deals coming in retail, media and printing.

Companies are looking to broaden their customer base....

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Oil & Gas (Short Underwriting & Defaults)

Sometimes distressed investing returns get upended by practical realities. The question is: were those realities accounted for in the underwriting?

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Education and Tech (Short Cloudless PE-owned Software)

Blackboard Inc. is in Trouble

There’s been a lot of news circling around Blackboard Inc. these days. Even children aren’t out of bounds for the distressed vultures, it seems.

Blackboard is a provider of enterprise tech software solutions to the education industry (as well as the government and some businesses); it peddles, among other things, a “learning management system,” virtual classrooms, education analytics (i.e., test scores), and marketing and recruiting services. It is meant to be a one-stop shop for educational providers’ needs.

Back in July of 2011, Providence Equity Partners (“PEP”) took the Nasdaq-listed company private in an all-cash transaction valued at...

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Distressed Debt Funds Fundraise (Long Market Timing)

At the Wharton Distressed Investing Conference in late February, Marathon Capital Management’s Bruce Richards said that his firm was delaying fundraising new capital. He noted that while he fully expects the cycle to turn and, consequently, that there’ll be a plentiful amount of distressed opportunities, he doesn’t want to mis-time the raise in such a way that his lock-up will expire midway through the investment horizon.

It seems others are of the view that now is the time. Per The Financial Times:

A growing number of US hedge funds specialising in distressed debt are raising money in anticipation that the next economic downturn will punish companies that have borrowed record amounts since the financial crisis.

Mudrick Capital, for instance, is reportedly raising a second fund that will have a five-year lockup and only charge fees upon capital investment. The fundraising goal is December 1. Carry the 1, add the 5, and that effectively means that he’ll have through 2024 to invest.

Marathon Capital had better hope there are still LPs out there looking to fund the asset class. More from FT:

Mudrick Capital is not the only fund preparing for an eventual downturn in a US economy where growth is accelerating this quarter. Strategic Value Partners in May raised almost $3bn to pounce on distressed bonds and loans, while Sheru Chowdhry, formerly co-portfolio manager of the Paulson Credit Opportunities fund, launched DSC Meridian Capital at the start of June.

In total, seven distressed debt funds have raised money this year, with a record average size of $2.2bn, according to data from Preqin. The largest is the GSO Capital Solutions Fund III, which closed in April after drumming up $7.4bn in the fourth-biggest distressed debt fundraising ever.

With tariffs, a trade war, rising interest rates, ramifications relating to tax deductibility in Tax Reform, secular pressures, auto loan delinquencies and more, many people seem to think a downturn is on the horizon. The question is when? Someone is bound to get the timing right.

Don’t. Mess. With. Daisy. Chapter 4. (Petsmart: Long Asset-Stripping Shenanigans)

Man this dog series (and John Wick referencing) is fun. With regard to Petsmart Inc., we previously we wrote:

The company financed the purchase with a two-part debt offering of (a) $1.35 billion of ‘25 8.875% senior secured notes and (b) $650 million of ‘25 5.875% unsecured notes. Rounding out the capital structure is a $750 million ABL, a $4.3 billion cov-lite first-lien term loan and $1.9 billion cov-lite ‘23 senior unsecured notes. Let us help you out here: 1+2+3+4 = $8.2 billion in debt. The equity sponsors, BC PartnersGICLongview Asset ManagementCaisse de dépôt et placement du Québec and StepStone Group, helped by writing a $1.35 billion new equity check.

That capital structure refresher is important…

Taking a page out of J.Crew’s asset-stripping, litigation-inducing, bird-flip-to-senior-lenders-activating playbook, Petsmart this week announced that it moved a 16.5% stake in Chewy.com (a/k/a the savior) to an unrestricted subsidiary — unironically using a sponsor dividend mechanic for the transaction; it also dividended 20% of the equity in Chewy.com to its parent company, Argos Holdings, an entity controlled by private equity firm BC Partners. Consequently, Chewy.com is no longer a wholly-owned subsidiary of Petsmart. Moreover, per The Financial Times,

“Chewy will no longer guarantee PetSmart's debt, according to Xtract Research, though the remaining 63.5 per cent of the shares will still be pledged to secure term loans and senior bonds.”

We love financial shenanigans that weaken lender collateral packages to the apparent benefit of junior creditors and private equity sponsors. Particularly when they’re done so quickly after the original transaction!

How did the market react? Well, per Bloomberg, initially:

PetSmart’s bonds rallied as the move of the online vendor’s assets was seen as less aggressive than what bondholders had originally priced in, according to the people, who said the initial buyers of the notes have unloaded the positions. Investors sold PetSmart’s debt last year on fears it would sell or spin off as much as 100 percent of the Chewy equity to the private equity owner, removing it from the pool of assets they have recourse to as bondholders.

Haha, right. So instead of getting potentially 100% effed, bondholders only got 33% effed. Can you say: Credit positive!? This is what makes the distressed world just so unmistakably poetic and nasty at the same time: everything is largely a function of…well…you guessed it: asset price and asset value. With the par guys out and buyers at distressed levels in, “credit positive” is entirely relative.

Anyway, more from Bloomberg,

The company’s management said that said they will continue to actively monitor the capital structure and potentially pursue additional strategic opportunities to extend debt maturities, reduce overall leverage and invest in the business, according to the people. Management didn’t have a question and answer portion at the end of the call.

Of course not. Why would they? The first question would be “By ‘reduce overall leverage’ does that mean issuing new bonds secured by the newly siphoned off equity of (valuable?) IP in exchange for the cov-lite unsecured notes?” Even Eli Manning couldn’t so obviously telegraph his next move (The Financial Times, citing Covenant Review, cites some other options here).

This bit is great:

Petsmart’s transfer of assets to an unrestricted subsidiary was not surprising given what J. Crew was able to do with its transfer of intellectual property under its loan documents, James Wallick of Xtract Research said in an interview. The move is “symptomatic” of the current market for loans and bonds, where agreements “are so flexible that you can do a transaction such as this.”

Hahaha. Man people love to gripe about the capital markets these days. Said another way,

Mmmm hmmm. Yield, baby, yield.