💰All Hail Private Equity💰

Private Equity Rules the Roost (Long Following the Money)

So, like, private equity is apparently a big deal. Who knew?

Readers of PETITION are very familiar with the growing influence, and impact of, private equity. We wouldn’t have juicy dramatic bankruptcies like Toys R UsNine West and others to write about without leveraged buyouts, excessive leverage, management fees, and dividend recapitalizations. Private equity is big M&A business. Private equity is also big bankruptcy business. And it just gets bigger and bigger. On both fronts.

The American Lawyer recently wrote:

Private equity is pushing past its pre-recession heights and it is not expected to slow down. Mergermarket states that the value of private equity deals struck in the first half of 2018 set a record. PricewaterhouseCoopers expects that the assets under management in the private equity industry will more than double from $4.7 trillion in 2016 to $10.2 trillion in 2025.

With twice as much dry powder to spend on deals, private equity firms will play a large role in determining the financial winners and losers of the Am Law 100 over the next five-plus years. It amounts to a power shift from traditional Wall Street banking clients and their preferred, so-called white-shoe firms to those other outfits that advise hard-charging private equity leaders.

Indeed, PE deal flow through the first half of the year was up 2% compared to 1H 2017:

In August, the American Investment Council noted that there was $353 billion of dry powder leading into 2018. No wonder mega-deals like Refinitiv and Envision Healthcare are getting done. But, more to the point, big private equity is leading to big biglaw business, big league. Say that five times fast.

The American Lawyer continues:

It is hard to find law firm managing partners who don’t acknowledge the attraction of private equity clients. Their deals act as a lure, catching work for a variety of practice groups: tax, M&A, finance and employee benefits. And lawyers often end up handling legal work for the very companies they help private equity holders buy. Then, of course, there is always the sale of that business. A single private equity deal for one of the big buyout firms can generate fees ranging from $1 million to $10 million, sources say.

“It’s kind of like there’s a perfect storm taking all those things into consideration that makes private equity a big driver in the success of many firms, and an aspirational growth priority in many more firms,” says Kent Zimmermann, who does law firm strategy consulting at The Zeughauser Group.

Judging by league tables that track deals (somewhat imperfectly, as they are self-reported by firms), Kirkland has a leading position in the practice. According to Mergermarket, the firm handled 1,184 private equity deals from 2013 through this June. Latham is closest with 609. Ropes & Gray handled 323, while Simpson Thacher signed up 319.

Hey! What about “catching work” for the restructuring practice groups? Why is restructuring always the red-headed step child? Plenty of restructuring work has been thrown off by large private equity clients. And Kirkland has dominated there, too.

Which would also help explain Kirkland’s tremendous growth in New York. Per Crain’s New York Business:

In just three years, Kirkland & Ellis has grown massively. The company, ranked 12th on the 2015 Crain's list of New York's largest law firms, has increased its local lawyer count by 61% to climb into the No. 4 spot.

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Much of that growth has come in its corporate and securities practice, where Kirkland's attorney count has nearly doubled in three years. The 110-year-old firm's expansion in this area is by design, said Peter Zeughauser, who chairs the Zeughauser Group legal consultancy.

"There aren't many firms like Kirkland that are so focused on strategy," Zeughauser said. "Their strategy is three-pronged: private equity, complex litigation and restructuring. New York is the heart of these industries, and Kirkland has built a lot of momentum by having everyone row in the same direction. They've been able to substantially outperform the market in terms of revenue and profit."

Kirkland's revenue grew by 19.4% last year, according to The American Lawyer, a particularly remarkable increase, given that it was previously $2.7 billion. Zeughauser has heard that a growth rate exceeding 25% is in the cards for this year. The firm declined to comment on whether that prediction will hold, but any further expansion beyond the $3 billion threshold will put Kirkland's performance beyond the reach of most competitors.

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Zeughauser, the consultant featured in both articles, thinks all of this Kirkland success is going to lead to law firm consolidation. Kirkland has been pulling top PE lawyers away from other firms. To keep up, he says, other firms will need to join forces — especially if they want to retain and/or draw top PE talent at salaries comparable to Kirkland. We’re getting PTSD flashbacks to the Dewey Leboeuf collapse.

As for restructuring? This growth applies there too — regardless of whether these outlets want to acknowledge it. Word is that 40+ first year associates started in Kirkland’s bankruptcy group recently. That’s a lot of mouths to feed. Fortunately, PE portfolio companies don’t appear to stop going bankrupt anytime soon. Kirkland’s bankruptcy market share, therefore, isn’t going anywhere. Except, maybe,…up.

That is a scary proposition for the competition. And those who don’t feast at Kirkland’s table — whether that means financial advisors or…gulp…judges.

*****

Apropos, on Monday, Massachusetts-based Rocket Software, “a global technology provider and leader in developing and delivering enterprise modernization and optimization solutions,” announced a transaction pursuant to which Bain Capital Private Equity is acquiring a majority stake in the company at a valuation of $2b.

Dechert LLP represented Rocket Software in the deal. Who had the private equity buyer? Well, Kirkland & Ellis, of course.

We can’t wait to see what the terms of the debt on the transaction look like.

*****

Speaking of Nine West, Kirkland & Ellis and power dynamics, we’d be remiss if we didn’t point out that a potential fight in the Nine West case has legs. Back in May, in “⚡️’Independent’ Directors Under Attack⚡️,” we noted that the Nine West official committee of unsecured creditors’ was pursuing efforts to potentially pierce the independent director narrative (a la Payless Shoesource) and go after the debtor’s private equity sponsor. We wrote:

In other words, Akin Gump is pushing back against the company’s and the directors’ proposed subjugation of its committee responsibility. They are pushing back on directors’ poor and drawn-out management of the process; they are underscoring an inherent conflict; they are highlighting how directors know how their bread is buttered. Put simply: it is awfully hard for a director to call out a private equity shop or a law firm when he/she is dependent on both for the next board seat. For the next paycheck.

Query whether Akin continues to push hard on this. (The hearing on the DIP was adjourned.)

The industry would stand to benefit if they did.

Well, on Monday, counsel to the Nine West committee, Akin Gump Strauss Hauer & Feld LLP, filed a motion under seal (Docket 717) seeking standing to prosecute certain claims on behalf of the Nine West estate arising out of the leveraged buyout of Jones Inc. and related transactions by Sycamore Partners Management L.P. This motion is the culmination of a multi-month process of discovery, including a review of 108,000 documents. Accompanying the motion was a 42-page declaration (Docket 719) from an Akin partner which was redacted and therefore shows f*ck-all and really irritates the hell out of us. As we always say, bankruptcy is an inherently transparent process…except when it isn’t. Which is often. Creditors of the estate, therefore, are victims of an information dislocation here as they cannot weigh the strength of the committee’s arguments in real time. Lovely.

What do we know? We know that — if Akin’s $1.72mm(!!) fee application for the month of August (Docket 705) is any indication — the committee’s opposition will cost the estate. Clearly, it will be getting paid for its efforts here. Indeed, THREE restructuring partners…yes, THREE, billed a considerable amount of time to the case in August (good summer guys?), each at a rate of over $1k/hour (nevermind litigation partners, etc.). Who knew that a task like “Review and revise chart re: debt holdings” could take so much time?🤔

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That’s a $10k chart. That chart better be AI-powered and hurl stats and figures at the Judge in augmented reality to justify the fees it took to put together (it’s a good thing it’s redacted, we suppose).

Speaking of fees it takes to put something together, this is ludicrous:

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The debtor has to pay committee counsel $100k for it to put together an application to get paid? For heaven’s sake. Even committee members should be up in arms about that.

And people wonder why clients are reluctant to file for bankruptcy.

*****

Speaking of independent directors, one other note…on the fallacy of the “independent” director in bankruptcy. Yesterday, October 9, Sears Holdings Corporation ($SHLD)announced that it had appointed a new independent director to its board. To us, this raised two obvious questions: how many boards can one human being reasonably sit on and add real value? At what point does a director run into the law of diminishing returns? Last we checked, it’s impossible to scale a single person.

But we may have been off the mark. One PETITION reader emailed us and asked:

The question you want to be asking is "what sham transaction that probably benefits insiders is the independent director being appointed to bless" or "what sham transaction that benefitted insiders is the independent director being appointed to "investigate" and find nothing untoward with?"

Those are good questions. Something tells us we’re about to find out. And soon.

Something also tells us that its no coincidence that the rise of the “independent fiduciary” directly correlates to the rise of fees in bankruptcy.

Tell us we’re wrong: petition@petition11.com.

Oil & Gas is Back Baby

Long the West Texas’ Permian Basin; Short Anadarko

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If you’re Steve RogersEncino Man, or were otherwise frozen somehow from 2014 through 2017 and missed the oil and gas downturn, Bethany McLean’s “Saudi America” will give you a nice high-level overview of American oil policy and fracking. It discusses Aubrey McClendon, the Obama-era change oil export policy, President Trump’s notion of energy independence, the rise of the West Texas’ Permian basin and more. She writes:

“What people still fail to understand is that the most cyclical number we have is the theoretical break-even,” one oil man says. “There will be stories about how the $40 break-even became the $70 break-even, and people will say ‘Who lied to me?’”

And so it is that the most important factor in the comeback of shale is the same thing that started the boom in the first place: The availability of capital. “It came back because Wall Street was there,” says longtime short-seller Jim Chanos. In 2017, U.S. frackers raised $60 billion in debt, up almost 30 percent since 2016, according to Dealogic.

Wall Street’s willingness to fund money-losing shale operators is, in turn, a reflection of ultra-low interest rates. That poses a twofold risk to shale companies. In his paper for Columbia’s Center of Global Energy Policy, Amir Azar noted that if interest rates rose, it would wipe out a significant portion of the improvement in break-even costs.

But low interest rates haven’t just meant lower borrowing costs for debt-laden companies. The lack of return elsewhere also let pension funds, which need to be able to pay retirees, to invest massive amounts of money with hedge funds that invest in high yield debt, like that of energy firms, and with private equity firms — which, in turn, shoveled money into shale companies, because in a world devoid of growth, shale at least was growing. Which explains why Lambert, portfolio manager of Nassau Re, says “Pension funds were enablers of the U.S. energy revolution.”

Ah, yield baby yield.

A lot of the U.S. energy revolution and recovery from ‘14-’17 is coming from the West Texas’ Permian basin. McLean writes:

In 2010, the Permian Basin was producing just shy of 1 million barrels a day. In 2017, that had more than doubled to over 2.5 million barrels a day. By August, output from the Permian alone exceeded that of 8 of the 13 members of OPEC, according to Bloomberg. The International Energy Agency predicts that output will hit more than 4 million barrels a day within a few years. Production from the Permian is the primary driver behind skyrocketing estimates of how much oil the U.S. will produce.

Apropos, Bloomberg noted this week:

To get a toehold in the prolific Permian Basin, private equity is increasingly betting on a relatively obscure, and potentially risky, part of the pipeline industry.

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies, according to Matthew Phillips, an analyst at Guggenheim Securities LLC.

Specifically, Bloomberg is referring to midstream companies manufacturing gathering and processing pipeline assets that transport oil and gas across states. Producers commit to pay for space in the pipes over a period of years. Restructuring professionals are very familiar with these gathering contracts: they were the subject of many a dispute during the recent downturn.

…investors in gathering pipes and processing plants are forced to lean on long-term projections, since their projects depend on continuous output over time from the same area.

“Any time there’s massive supply growth, there is some risk-seeking behavior,” said Jeff Jorgensen, portfolio manager and director of research at Brookfield Asset Management Inc.’s Public Securities Group. There’s a tendency by some to “invest in production profiles that are, let’s just say, hilariously aggressive in their assumptions” for the future, he said.

It’s easy to see where that aggressiveness is coming from. Researcher IHS Markit predicts output in the Permian Basin will double by 2023 to reach 5.4 million barrels a day. That’s more than every OPEC country except Saudi Arabia. By 2035, it could hit 6.3 million barrels, according to Wood Mackenzie.

Bloomberg continues:

…with the surge of private equity money giving way to smaller players that may be taking on added debt to pay for pricey projects, the risk increases dramatically.

“There’s definitely some sloppiness in the gathering and processing space,” she said. “The cash flow isn’t going to be what they expected, so we could see some of the smaller players financially weaken, and that may lead to consolidation.”

With oil prices on the rise, however, the risk may seem worth taking. Memories are short. And confidence in break-even costs must be through the roof. Regardless of whether President Trump is happy with oil prices where they are.

The bottom line is that in this oil and gas recovery, there are clear winners and losers. The Permian is a big winner. This explains the recent S-1 filing of Riley Exploration — Permian LLC ($REPX)(owned by Yorktown Partners LLCBluescape Energy Partners LLC and Boomer Petroleum LLC), which has 65k+ net acres in the Permian as of June 30, 2018. Look at that name: they’re clearly sending a message that screams “pureplay Permian exploration and development company.” It’s like companies putting “.com” in their name during the dot.com bubble and “blockchain” in their name in the more recent crypto bubble. Smart move.

The Bakken in North Dakota appears to be back too. Per Bloomberg:

North Dakota’s oil production surged to a new record in July, putting the mid-western state on par with OPEC member Venezuela.

Home to the Bakken shale play, North Dakota pumped 1.27 million barrels a day in July, according to state figures released Friday. That’s roughly the same output as Venezuela during the month. The South American nation, whose oil industry has collapsed amid a prolonged financial crisis, saw production fall further in August to 1.24 million barrels a day -- about half the level seen in early 2016, according to data from OPEC secondary sources.

Where are the losers? Look at the Anadarko/Woodford area (read: West Oklahoma). In quite the juxtaposition to Riley Exploration, this week Tapstone Energy, a Blackstone-backed oil and gas exploration and production company withdrew its proposed $400mm IPO. Those closely watching Gastar Exploration Inc. ($GSTC) will find it located there too. The stock was delisted, trades over-the-counter at $0.06/share. The bankruptcy clock is ticking.

Like we said. Winners and losers.

What to Make of the Credit Cycle. Part 14. Refinitiv Edition.

Long Blackstone. Short Market Timing.

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🎶 Sing it with us now: “Yield, baby, yield.” 🎼

Let’s pretend for a second that you’re a trader “sitting on the desk” of a fund with a high yield mandate. Limited partners have given your Portfolio Manager millions upon millions (if not billions) of dollars to get access to — and active management of — high yield debt. They expect your PM and the team to deploy that capital. That’s what you said you’d do when you were out pounding the pavement fundraising. They don’t want to pay you whatever your management fee is for you to simply be sitting in cash, waiting on the sidelines counting your “dry powder.” So when a big issuance goes out to market, you’ve got to make your move. The pressure is on.

The first order of business it to simply make sure that you even get in the room. You’d better be on your game. There’s a lot of appetite for yield these days, so you better be working those phones, dialing up that “left lead” clown you suffered beers with a few weeks back with the hope of getting an opportunity to put in an allocation. You’re dialing and dialing and hoping that he doesn’t remember that your PM passed on — much to your chagrin — the last 4 or 5 looks that clown — let’s call him Krusty — gave you. Fingers crossed.

Your PM is pacing behind you. It’s creeping you out. Angst fills the room. The desk lawyer is running around screaming bloody hell about some covenants or something. Maybe it was a lack thereof. You’re not sure. You don’t care, damn it. Those LPs want that money deployed so you’re damn well gonna deploy it. Forget about covenants. Forget about risk. That lawyer can pound sand. Literally nobody cares. Because you and your team are super savvy. Surely you’ll be able to dump these turds of loans and bonds before the market speaks and the debt trades down. Or before all liquidity dries up. Either way, you’ll get out. You’re sure of it. Market timing is your jam.

You finally get through. Krusty says “what’s your number?” You turn to your PM and without much time to really crunch numbers — after all, the yield, the potential discount, the Euro piece vs. the US piece all keep changing — he shrugs and throws out a hefty number. And then does the Sam Cassell dance. You smile. There’s momentarily silence on the other end. Finally, Krusty says he’ll call you back; he seems wildly unimpressed. Your PM shrinks.

You know this same scene is playing out on trading desks all over Wall Street time and time again when there’s a juicy new issuance.

And so does Blackstone. So does Refinitiv.

This week the high yield universe worked itself into a tizzy as Refinitiv priced and issued $13.5 billion of debt to finance Blackstone’s multi-billion dollar ~55% takeover of Thomson Reuters’ Financial & Risk division. Why is this a big deal? Well, in part, because its a big deal. And the lack of (high yield) supply has led to pent up demand. Pent up demand can lead to some interesting compromises.

On September 8, the International Financing Review wrote:

The debt package is divided into US$8bn of loans and US$5.5bn of high-yield bonds. Those debts, combined with separate payment-in-kind notes (with a 14.5% coupon), will result in annual interest payments of US$880m at current price talk. A separate US$750m revolving credit facility will also need servicing.

“The banks had no choice but to price it attractively and it’ll be interesting to see how it goes,” a loan investor in London said. (emphasis added).

Furthermore,

The deal is being marketed with leverage of 4.25 times secured and 5.25 times unsecured, based on adjusted Ebitda of US$2.5bn, which includes US$650m of cost savings from the business’s reported Ebitda of US$1.9bn.

Wait. Take a step back. Cost savings? What cost savings? Blackstone is claiming that they can take $650mm out of the business thereby driving the leverage ratio down. That’s quite a gamble for investors to take. Particularly combined with loose interpretations of EBITDA and considerable add-backs.

The International Financing Review quoted some investors:

A portfolio manager in London said that he had calculated that leverage for the deal is “nearer six and seven times”.

“It’s very late cycle. I don’t really like it when you see a deal with this order of magnitude of projected cost savings as you really don’t know if and when they will be realised,” he said.

“It will be a bit of a test for the market given the size of the deal. But Blackstone and its partners have a good reputation and deep pockets.”

Moody’s and Fitch put leverage between 6.1x and 7.6x.

Covenant Review was nonplussed about the bond protections. It wrote:

“The notes are being marketed with extremely defective sponsor-style covenants riddled with flaws and loopholes that reflect the worst excesses of covenant erosion over the last two years.”

Tell us how you really feel.

Reuters channeled the ghosts of TXU:

The return of big buyouts to the leveraged finance market has rekindled memories of the 2006 and 2007 bad old days of risky underwriting and excessive debt.

So, in the end, how DID the issuance go?

The Wall Street Journal wrote:

One of the largest-ever sales of speculative-grade debt was completed with ease on Tuesday, a sign of the favorable environment for U.S. borrowers at a time of robust economic growth and strong demand from investors.

The $13.5 billion sale—which a Blackstone Group LP-led investor group is using to acquire a 55% stake in a Thomson Reuters Corp. data business called Refinitiv—comprised $9.25 billion of loans and $4.25 billion of secured and unsecured bonds, with different pieces denominated in U.S. dollars and euros.

Including a $750 million revolving credit line, the bond-and-loan deal amounted to the ninth-largest leveraged financing on record in the U.S. and Europe, and was the fourth-largest since the financial crisis, according to LCD, a unit of S&P Global Market Intelligence.

Said another way, demand was so high for the issuance that — aside from upsizing the loan component by $1.25 billion (with a corresponding bond decrease) and a reduction of future permitted debt incurrence — the company was able to offer bond investors LOWER interest rates at par, despite the fact that both Moody’s and S&P Global Ratings rated the issuance near the bottom of the ratings spectrum. Read: thanks to fervent demand, the banks were able to price a wee bit less aggressively than originally planned. That includes the loans: the company was also able to decrease the original guided discount (“OID”) for investors.

Per Bloombergorders

“…total[ed] double the $13.5 billion of bonds and loans it needed to raise. The scale of the response was spurred on by a ravenous bid from collateralized loan obligations and other investors amid fears that there may be fewer new deals going into the fourth quarter."

🎶 One more time: “Yield, baby, yield.” 🎼

So here you had a 2x over-subscription despite some troubling characteristics:

High leverage wasn’t the only way Refinitiv has tested investors. Under the proposed terms of its bonds, the company could pay dividends to its owners even if it came under severe financial distress, a provision that the research firm Covenant Review described as “wildly off market.”

Back to International Financing Review quoting a high yield investor:

“It got to the point where the only thing I liked about the (Refinitiv) deal was the yield. And I’ve learned after 25 years in this business, that’s not enough.”

Among his concerns were business challenges that the Refinitiv business has already faced from competitors like Bloomberg and FactSet. But Blackstone’s ambitious cost-savings target also made him leery.

“When you look at the investment thesis of the sponsor, it’s very much about achieving cost synergies,” said the investor.

“The synergies they forecast are based on their story that they know how to do this better as sponsors than the corporate parent.”

Reasonable minds can debate the merits and reality of sponsor-driven cost “synergies.” But let’s be honest. Nobody is investing in this capital structure because they are whole-hearted endorsers of the Blackstone-promulgated cost-reduction narrative.

“Among the rationales for investors is confidence in the economy - it’s looking good right now, it’s looking good next year, and the belief that they can sell before the quality of the debt deteriorates,” Christina Padgett, a senior vice-president at Moody’s, told IFR.

In other words, market timing is their jam.

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:

Screen Shot 2018-07-01 at 10.12.03 AM.png

AND this:

Screen Shot 2018-07-01 at 10.13.04 AM.png

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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