🎆Lehman = Anniversary Fever🎆

Initiate the Deluge of Lehman Retrospectives (Short History)

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

Bloomberg’s Matt Levine writes:

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

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

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

Levine continues:

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

He’s got a point.

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

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

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

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

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

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

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

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

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

💰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.

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

*****

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

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

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

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

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

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

These aren’t one-offs.

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

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

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

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

Your next hospital visit may be powered by private equity.

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

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

Here’s a choice quote for you:

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

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

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

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

Nevermind this aspect:

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

Your next dental exam powered by private equity.

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

Your next cataracts surgery powered by private equity.

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

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

🍾Happy Anniversary, Tower Records!!🍾

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

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

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

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

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

CBSNews added:

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

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

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

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

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

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

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

Long Private Markets as Public Markets

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

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

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

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

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

He goes on to state some characteristics of an ABC:

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

• There is no discharge in an ABC.

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

And some benefits of an ABC:

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

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

• Lower admin costs;

• Lower visibility to an ABC than a bankruptcy filing;

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

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

Asleep yet? 😴

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

ABCs also have limitations:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

So, what’s the problem?

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

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

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

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

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

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

And then there are the public markets.

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

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

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

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

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

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

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

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

She continued:

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

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

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

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

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

The 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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😴Mattress Firm's Nightmare😴

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

Source: PETITION LLC

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

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

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

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

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🛋There's Disruption Afoot in the Furniture Space🛋

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

RetailDive notes:

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

Accordingly, GartnerL2 cautions that:

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

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

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

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

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

EB-5 Investors Become Bankruptcy Experts

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Private Equity & Toys R Us (Long Active Management. Yield Baby Yield)

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McKinsey Keeps Getting Burned (Long Newspaper Relationships)

We’ve previously covered the pending lawsuit by Jay Alix against McKinsey here. It’s next level and totally worth refreshing your recollection. You’ll recall the sequence of events: first, a Wall Street Journal article highlighted McKinsey’s failure to disclose potential conflicts in a variety of restructuring engagements and then Jay Alix immediately launched his lawsuit alleging racketeering, bribery, etc. Curious timing, as we said at the time. We wrote:

In “McKinsey Gets Thrown Under the Bus (Long Relationships with the WSJ),” we began,

Okay, this WSJ article is bananas. What are the chances that Jay Alix has a direct line in to Gerard Baker?

Given that the WSJ piece is now front in center in the “Complaint and Jury Demand” filed by Jay Alix in Alix v. McKinsey & Co. Inc., et al (page 4, paragraph 11), wethinks the chances are pretttttttty prettttttty high (we’re 100% speculating here so take this with the usual PETITION grain of salt).

Well, for McKinsey, the hits just keep on coming.

Subsequent to the above, the Wall Street Journal reported that a McKinsey retirement fund held investments that hinged on the result of some of the very bankruptcy cases that McKinsey RTS worked on. WHOOPS.

This week, Representative Andy Biggs of Arizona asked the director of the U.S. Trustee Program, a Justice Department unit, for clarity on the requirements governing how bankruptcy professionals comply with the Bankruptcy Code’s “disinterestedness” standard. Per The Wall Street Journal, Representative Biggs is “concerned that undisclosed conflicts at McKinsey & Co.’s restructuring unit may be compromising the nation’s bankruptcy system.” With all due respect to Mr. Biggs, there are greater dangers to the integrity of the bankruptcy system than the disclosure of McKinsey’s client list. Like some of the points made here (conflicts, generally). And here (independent directors). Or here (professionals’ fees). Or here (venue shenanigans and judges “playing ball”). This wouldn’t be the first time that a Congressman exhibited a negligible understanding of an issue. But we digress.

Anyway, like clockwork, Jay Alix pounced. This week, as (also) reported in The Wall Street Journal (which seems conveniently all over this drama), Mr. Alix filed papers in the U.S. Bankruptcy Court in Richmond Virginia asking the bankruptcy judge to consider reopening the bankruptcy case of Alpha Natural Resources, a case that confirmed eons ago. Per the WSJ:

The revelation that McKinsey had a financial interest in the outcome of Alpha’s bankruptcy warrants reopening the case and revisiting whether the firm failed to properly disclose potential conflicts of interest, according to Mr. Alix.

First, HAHAHAHAHA. Right, ok. We’re sure the judge will reopen the case on this basis.

Second, the article is entitled “Disclosure Advocate Seeks to Reopen Coal Miner’s Bankruptcy.” Therein, the WSJ deadpans:

Mr. Alix has been relentless in his battle with McKinsey. He is currently pursuing litigation against the firm in several courts, hiring some of the country’s top lawyers and ethics experts to help him take on the consulting giant.

Mr. Alix has denied McKinsey’s accusation that he is seeking a competitive advantage for AlixPartners, the prominent restructuring firm he retired from in 2006 but retains a minority ownership stake in.

Right. Of course he isn’t looking to take out a competitor (that once poached his employees) and/or juice his equity. Promise.

He’s a mere “disclosure advocate.”

⚡️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

Ah, the sacrifices.

Healthcare Distress (Long Divine Intervention)

Literally a week ago in “💥KKR Effectively Tells Bernie Sanders to Pound Sand💥” we wrote:

Remember all of those early year surveys about where the distressed activity was going to be? Yeah, so do we. Everyone was bullish about healthcare distress. And, sure, there have been pockets here and there but nothing that’s been truly mind-blowing in that sector. In other words, wishful thinking. Unless you’re DLA Piper (Orion Healthcare Corp., 4 West Holdings LLC), the (limited) healthcare activity has meant basically f*ck all for you.

The Gods have acted to make us look stupid. Look! Healthcare distress!

Neighbors Legacy Holdings Inc., an operator of 22 freestanding emergency centers throughout the state of Texas filed for bankruptcy on July 12, 2018. The company blames its filing on "financial difficulties caused in large part by increased competition, less favorable insurance payor conditions, declining revenues, and disproportionate overhead costs as compared to their operational income." In other words, its owners did too much too fast, taking on too much debt to expand too rapidly in a space that requires significant upfront capital investment in exchange for a 12-18 month lag in cash flow generation. Initiate death spiral. 

The company's financial numbers look brutal. Per the First Day Declaration:

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Footwear Brands Reap Heaps of VC Investment (Short B&M Footwear Retailers)

Back in March, in “Nine West & the Brand-Based DTC Megatrend,” we noted the following:

The Walking Company. Payless Shoesource. Aerosoles. The bankruptcy court dockets have been replete with third-party sellers of footwear with bursting brick-and-mortar footprints, high leverage, scant consumer data, old stodgy reputations and, realistically speaking, limited brand value. Mere days away from a Nine West bankruptcy filing, we can’t help but to think about how quickly the retail landscape is changing and the impact of brands. Why? Presumably, Nine West will file, close the majority of - if not all of - its brick-and-mortar stores and transfer its brand IP to its creditors (or a new buyer). For whatever its brand is worth. We suppose the company’s lenders - likely to receive the company’s IP in a debt-for-equity swap, will soon find out. We suspect “not a hell of a whole lot”.

Shortly thereafter, Nine West did file for bankruptcy but we were a little off on the rest. That is, unless $340mm constitutes “not a hell of a whole lot.” That amount, landed on after a competitive bidding process, resulted in a greater-than-expected value to Nine West’s estate. Remember: the company filed for bankruptcy with a stalking horse bidder offering “approximately $200 million (inclusive of the above-stated $123 million allocation to IP, subject to adjustment).” This is where bankruptcy functions as a bit of alternative reality: $340 million is a good result for a company with $1.6 billion of debt, exclusive of any and all trade debt — particularly when the opening bid is meaningfully lower. For a more fulsome refresher on Nine West’s bankruptcy filing, go here.

Subsequent to Nine West’s filing, the tombstones for footwear retailers continued to pile up. For instance, in mid-May, The Rockport Company LLC filed for bankruptcy with a telling narrative. We highlighted:

The company notes, "[o]ver the last several years the Debtors have faced a highly promotional and competitive retail environment, underscored by a shift in customer preference for online shopping." And it notes further, "[t]he unfavorable performance of the Acquired Stores in the current retail environment has made it difficult for the Debtors to maintain sufficient liquidity and to operate their business outside of Chapter 11." PETITION NOTE: This is like a broken record, already.

We continued:

In light of this, armed with a $20 million new-money DIP credit facility (exclusive of rollup amounts) extended by its prepetition ABL lenders, the company has filed for bankruptcy to consummate a stalking horse-backed asset purchase agreement with CB Marathon Opco, LLC an affiliate of Charlesbank Equity Fund IX, Limited Partnership for the sale of the company's assets - OTHER THAN its North American assets — for, among other things, $150 million in cash. The buyer has a 25-day option to continue considering whether to purchase the North American assets but the company does "not expect there to be any significant interest in the North American Retail Assets." Read: the stores. The company, therefore, also filed a "store closing motion" so that it can expeditiously move to shutter its brick-and-mortar footprint at the expiration of the option. Ah, retail. 

And, ah, footwear. Check out this lineup:

And so we asked:

Given all of that, would you want Rockport’s brick-and-mortar business?

Answer: no. Apparently nobody did. And, in fact, nobody — other than the stalking horse, CB Marathon Opco, LLC — wanted any part of Rockport’s business.

On July 6, the company filed a notice that it cancelled its proposed auction. There were no qualified bidders, it noted, thereby making CB Marathon Opco, LLC the winning bidder by default. And given that the stalking horse agreement excluded the U.S. brick-and-mortar assets, those assets are now officially kaput. A hearing at which the bankruptcy court will bless the sale is scheduled for July 16. Aside from some additional administrative matters in the case, that hearing will mark a wretched ending for a company founded in the early 1970s.

*****

Juxtapose that doom and gloom with this Techcrunch piece about the rise of venture capital in footwear:

Over the past year-and-a-half, investors have tied up roughly $170 million in an assortment of shoe-related startups, according to an analysis of Crunchbase data. The vast majority is going to sellers and designers of footwear that people might actually want to walk in.

Top funding recipients are a varied bunch, including everything from used sneaker marketplaces to high-end designers to toddler play shoes. Startups are also experimenting with little-used materials, turning used plastic bottles, merino wool and other substances into chic wearables.

The piece continues:

It should be noted that recent footwear funding activity comes on the heels of some positive developments for the shoe industry.

Positive developments huh? “Some” must be the operative word given the preface above. There’s more:

First, this is a huge and growing industry. One recent report pegged the global footwear market at $246 billion in 2017, with annual growth rates of around 4.5 percent.

Second, public markets are strong. Shares of the world’s most valuable footwear company — Nike — have climbed more than 50 percent over the past nine months to reach a market cap of nearly $130 billion. Stocks of several smaller rivals, including Adidas, have also performed well.

Third, men are spending more on footwear. Though they’ve long been stereotyped as the gender with more restrained shoe-buying habits, men are putting more money into footwear and could be on track to close the spending gap.

And:

…one other bullish sneaker trend footwear analysts point to is the changing buying habits of women. Driven perhaps by a desire to walk more than a few blocks without being in pain, we’re buying fewer high heels and more sneakers.

The piece goes on to list a lineup of well-funded footwear companies. In marketplaces, GOAT and StockX. In streetwear, Stadium Goods. For children, Super Heroic. For comfort, Allbirds, Rothy’s, and Birdies. And the article neglected to mention Koio, Greats, and M. Gemi, to name a few. If you feel as if these names are unfamiliar because you didn’t see them at a brick-and-mortar footwear retailer in your last trip to the mall, well…yeah. That ought to explain a lot.

Interestingly, before unironically asking (and not entirely answering) whether any of these companies actually make money, the article also highlights Tamara Mellon,“a two-year-old brand that has raised more than $40 million to scale up a shoe design portfolio that runs the gamut from flats to spike heels.” Indeed, the company recently raised a $24mm Series B round* to grow its Italian-made pureplay e-commerce direct-to-consumer brand. In reality, though, Tamara Mellon is only technically two years old. It was around before 2016. In a different iteration. That iteration filed for bankruptcy.

In early 2016, Tamara Mellon Brand LLC filed for bankruptcy because of a liquidity crisis. And it couldn’t sufficiently raise capital outside of a chapter 11 filing to ensure its survival. After filing for bankruptcy, the company took on a $2mm debtor-in-possession credit facility from Ms. Mellon and, after combatting an equityholder-led “recharacterization”** challenge (paywall), swapped its term loan debt into equity. Winning prepetition equityholders like Ms. Mellon and venture capital firm New Enterprise Associates (NEA) came out with 16 and 31.1 percent of the equity, respectively. In turn, NEA capitalized the company to the tune of approximately $12mm.

Which highlights the obvious: not all of these companies will ultimately have renowned founders who merit second chances. A number of these high-flying e-commerce upstarts will fail; some of them will file for bankruptcy. The question is: as the funding rounds pour in from venture capitalists looking for the next big exit, how many other brands and shoe retailers will they push into bankruptcy first?

*****

*In October 2017, we wrote the following in “Sophia Amoruso's Nasty Gal Failure = Trite Lessons (Short Puffery)”:

We love how entrepreneurs are all about "move fast and break things" and "don't be afraid to fail" but then when they do, and do so badly, there is barely anything that really provides an in-depth post-mortem…Take, for instance, this piece of puffy garbage about Sophia Amoruso, which purports to inform readers about what Ms. Amoruso learned from Nasty Gal's rapid decline into bankruptcy. Instead it provides some evergreen inspirational advice that applies to virtually...well...everything and anything. TOTALLY USELESS.  

Apropos, the above-cited Fast Company piece is lip service Exhibit B. The piece notes:

Tamara Mellon cofounded Jimmy Choo with, well, Jimmy himself back in 1996. But in 2016, she decided to launch her own eponymous luxury shoe brand. It wasn’t easy, though: When she tried to go to high-end factories in Italy, she discovered that many refused to work with her, citing non-compete clauses with the Jimmy Choo brand.

But through persistence, she prevailed, and found factories that made shoes for other luxury brands.

We gather that what happened earlier in 2016 wasn’t relevant to the PR piece. Curious: is “persistence” a new euphemism for “bankruptcy”?

**If we understand what happened here correctly, other existing equityholders tried to recharacterize Ms. Mellon’s term loan holding as equity, effectively squashing her priority secured claim and demoting that claim to equal to or less than the equityholders’ claims. If successful, Ms. Mellon would not have been able to swap her debt for equity. Moreover, the other equityholders would have had a greater chance of a recovery on their claims. They failed, presumably recovering bupkis.

#BustedIPO: Tintri Inc. Files for Bankruptcy

What is the statute of limitations for declaring an IPO busted?

We previously wrote about Tintri Inc. ($TNTR) here and, frankly, there isn’t much to add other than the fact that company has, indeed, filed for bankruptcy. The filing is predicated upon a proposed 363 sale of the company’s assets as a “going concern” or a liquidation of the company’s intellectual property in what should be a fairly short stint in bankruptcy court. Shareholders likely to be wiped out include New Enterprise Associates (yes, the same firm mentioned above in the Tamara Mellon bit), Insight Venture Partners, Lightspeed Venture Partners and Silver Lake Kraftwerk.

Meanwhile, in the above-cited piece we also wrote:

Nothing like a $7 launch, a slight post-IPO uptick, and then a crash and burn. This should be a warning sign for anyone taking a look at Domo — another company that looks like it is exploring an IPO for liquidity to stay afloat.

This bit about Tintri''s financial position offers up an explanation for the bankruptcy filing -- in turn serving as a cautionary tale for investors in IPOs of companies that have massive burn rates:

"The company's revenue increased from $86 million in fiscal 2016 to $125.1 million in fiscal 2017, and to $125.9 million in fiscal 2018, representing year-over-year growth of 45% and 1 %, respectively. The company's net loss was $101.0 million, $105.8 million, and $157.7 million in fiscal 2016, 2017, and 2018, respectively. Total assets decreased from $158.1 million as of the end of fiscal 2016 to $104.9 million as of the end of fiscal 2017, and to $76.2 million as of the end of fiscal 2018, representing year-over-year change of 34% and 27%, respectively. The company attributed flat revenue growth in fiscal 2018 in part due to delayed and reduced purchases of products as a result of customer concerns about Tintri's financial condition, as well as a shift in its product mix toward lower-priced products, offset somewhat by increased support and maintenance revenue from its growing installed customer base. Ultimately, the company's sales levels have not experienced a level of growth sufficient to address its cash burn rate and sustain its business."

With trends like those, it's no surprise that the IPO generated less capital than the company expected. More from the company:

"Tintri's orders for new products declined, it lost a few key customers and, consequently, its declining revenues led to the company's difficulties in meeting day-to-day expenses, as well as long-term debt obligations. A few months after its IPO, in December 2017, Tintri announced that it was in the process of considering strategic options and had retained investment bank advisors to assist it in this process."

As we previously noted a few weeks ago, "[t]here's no way any strategic buyer agrees to buy this thing without a 363 comfort order."  With Triplepoint Capital LLC agreeing to provide a $5.4mm DIP credit facility, this is precisely the path the company seeks to take.

*****

Meanwhile, Domo Inc. ($DOMO) is a Utah-based computer software company that recently IPO’d. Per Spark Capital’s Alex Clayton:

Domo recently drew down $100M from their credit facility and currently only has ~6 months of cash left with their current burn rate. Given they raised $730M in equity capital from investors and another $100M through their credit facility, it implies they have spent roughly $750M over the past 8 years to reach a little over $100M in ARR, an extraordinary and unprecedented amount of cash burn for a SaaS company. They have $72M in cash.

That was before the IPO. This is after the IPO:

Draw your own conclusions.

Healthcare (Short Predictions. Nobody Effing Knows Part II)

Remember all of those early year surveys about where the distressed activity was going to be? Yeah, so do we. Everyone was bullish about healthcare distress. And, sure, there have been pockets here and there but nothing that’s been truly mind-blowing in that sector. In other words, wishful thinking. Unless you’re DLA Piper LLP, the (limited) healthcare activity has meant basically f*ck all for you.

Fitch Ratings recently released a report indicating that it expects healthcare-related defaults to remain low. Choice bit:

"We don't see any catalyst for there to be a great increase in defaults in the sector," said Megan Neuburger, Fitch's team head for healthcare and an author of the report. "It tends to be a fairly stable sector from a cyclical perspective, so the drivers of bankruptcies tend to be more idiosyncratic."

In other words, the chief drivers of healthcare bankruptcies aren't the same as in other sectors, which are more influenced by economic downturns or factors related to the commodity cycle, she said. Neuburger said her team doesn't see any catalyst on the horizon that would prompt an uptick in healthcare defaults this year or in 2019.

We’ll see if the early 2019 surveys reflect this view.

💥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.”

Is Fairway Group Holdings Corp. Headed for Chapter 22?

We were tempted to just leave it alone at “yes,” but we’ll at least add what Moody’s had to say:

"Despite the lower debt burden following the company's emergence from bankruptcy in 2016, we believe Fairway's capital structure is unsustainable given weaker than anticipated operating performance and upcoming debt maturities," stated Moody's Vice President and lead analyst for the company, Mickey Chadha. "Fairway is facing an extremely promotional business environment, and with competitive openings in its markets expected to continue, the ability to improve profitability at a level sufficient to support the current capital structure looks highly suspect, rendering a further debt restructuring highly likely in our estimation over the next 12-18 months," added Chadha.

Furthermore:

The ratings reflect elevated risk of another requisite debt restructuring or distressed exchange given Fairway's deemed untenable capital structure, evidenced in part by very weak credit metrics, weak and eroding liquidity, and upcoming debt maturities including a $25 million LC facility that matures October 2018 and more than $100 million (including PIK interest) of senior secured term loans that mature in January 2020. Moody's estimates lease adjusted debt-to-EBITDA in excess of 10 times, and EBIT-to-interest of less than 1.0 time over the next twelve months.

Remember: this company already shed $140mm of secured debt and $8mm in annual interest expense in the last bankruptcy a mere two years ago. In the company’s Disclosure Statement, company counsel Weil Gotshal & Manges LLP wrote:

Upon emergence from bankruptcy, all borrowings under the DIP Term Loan will be converted into an exit facility on a first out basis leaving an estimated $42 million of cash and cash equivalents on Fairway’s balance sheet that will allow it to maintain its operations and satisfy its obligations in the ordinary course of business and position Fairway for long term success.

Not to get ahead of ourselves here as Moody’s can surely be wrong. But, are we crazy or has the definition of “long term success” dramatically changed?

Which begs an interesting series of questions. First, at what point do professionals who have multiple chapter 22s attached to their names start to feel the affect of that in the marketplace? At what point do they get credibility checked on plan feasibility by judges at the confirmation hearing? “Mr. Lawyer ABC and Mr. Restructuring Advisor XYZ. Could you please explain why I should believe a thing you say about feasibility given that your last [insert applicable number here] grocery restructurings have all ended up back in bankruptcy court within short order? Have you properly guided your client to a truly ‘feasible long term success’ trajectory? Or are you really just succumbing to the wishes of stakeholders at the other side of the table (cough, GSO) whose business you hope to obtain in the future?

To be fair, we suppose if you service a monopoly of cases is a given sector and that sector is going to hell in a hand basket the way the grocery space is the likelihood of repeat bankruptcies goes up. Still, you’d think management teams (and/or the sponsors) would start to question the value of “quals” when those quals all ultimately result in an expensive round-trip ticket back to bankruptcy court.

💩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.

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.”).