March 10, 2019
In January's "What to Make of the Credit Cycle. Part 25. (Long Warning Signs)," we discussed the leveraged loan market and, among many other things, highlighted the then-recent reports that KKR was planning to cut its leveraged loan exposure.
It seems pretty safe to say that this decision was partially informed by KKR's recent experience managing the $2b ex-Blackstone loan fund, Franklin Square Investment Corp. According to reporting by The Financial Times back in December, the Franklin Square fund (now FS-KKR Capital Corp) wrote down five loans between April and December last year. That must be lovely news for investors in the publicly-traded business development corporation ($FSK). Per the FT:
"Executives at Blackstone’s GSO credit arm approved the original loans. But KKR is now responsible for collecting the cash and assessing the loans’ value, and has taken a much gloomier view of their prospects. It has placed 28 percent of the portfolio on a list of deals that require close monitoring or are at risk of losing money, according to securities filings.
'KKR is a formidable group, but they probably weren’t anticipating the losses that came forth in the GSO book,' said Finian O’Shea, an analyst who covers private credit funds for Wells Fargo."
Strangely, this is obviously good news for professionals with restructuring experience:
"KKR’s credit division has been hiring restructuring specialists to beef up a dedicated team charged with salvaging value from troubled investments — a move that executives there say was planned when the FS-KKR portfolio began to deteriorate. KKR declined to comment, as did the fund’s co-manager, Franklin Square Investments."
Those specialists might get increasingly busy. FSK owned, as of December 31, 2018, first lien loans in Acosta Inc. (written down by the BDC's board to "fair value" from $19.2mm to $11.8mm), Charlotte Russe (yikes), CTI Foods (which was written down by $900k), and Z Gallerie (which had been written down from $31.9mm to $11.3mm). It also owns second lien paper in Belk Inc. (written down from $119.1mm to $94.7mm), CTI Foods, and Spencer Gifts LLC (written down from $30mm to $25.6mm). And subordinated debt in Sungard (written down by 80%). The BDC's equity holdings in Charlotte Russe and Nine West are now obviously worthless.
Lots of people are focused on BDCs given lending standards during this long bull run. If that portfolio is any indication, they should be.
Speaking of Z Gallerie, it filed for bankruptcy last weekend in the District of Delaware. It is a specialty-niche furniture retailer that has 76 stores across select states in the US. And this is its second trip into bankruptcy in 10 years. While we think that's too large a spread to really be a "chapter 22," its an ignominious feat nonetheless.
So another retailer in bankruptcy. We're all getting bored of this. And we're also getting bored of private equity firms helping drive companies into the ground. In this instance, Brentwood Associates, a $2.4b Los Angeles-based private equity purchased a 70% stake in the company in 2014 (and took two seats on the company's board of directors). At the time, Brentwood had this to say about the transaction:*
"Z Gallerie is a differentiated retailer in the home furnishings market with a very unique merchandise assortment. We see a significant opportunity to accelerate growth of the current retail store base."
But…well...not so much. This statement by the company's CRO is a pretty damning assessment of Brentwood's claim that they "build category-defining businesss through sustained, accelerated growth”:
"Following a transaction in 2014 in which the Zeidens sold majority control of Z Gallerie to Brentwood Associates (“Brentwood”), Z Gallerie’s overall performance has declined significantly. The reasons for these declines are mostly self-imposed: (i) a store footprint expansion did not meet performance targets, (ii) the addition of the Atlanta distribution center disrupted operations and increased costs, and (iii) the failure to timely invest enough capital in their e-commerce platform limited its growth. These missteps were exacerbated by macroeconomic trends in the brick and mortar retail industry and lower housing starts. As a result, net revenue and EBITDA declined during fiscal year 2018. With Z Gallerie’s current cash balances of less than $2 million, and no availability under its secured credit facilities, the commencement of these chapter 11 cases became necessary to ensure access to capital going forward."
That's brutal. Something tells us that Z Gallerie is going to make a swift disappearance from Brentwood's website.
Anyway, the company includes all kinds of optimistic language in its bankruptcy filing papers about how, after it closes 17 stores and executes on its business plan, it will be poised for success. It intends to enhance its e-commerce (currently 20% of sales), revamp its Atlanta distribution center, launch social media campaigns (long Facebook), and better train its employees (long Toys R Us PTSD). The company claims numbers have already been on the upswing since the holidays, including February same-store sales up 5% YOY.
Current optimism notwithstanding, make no mistake: this is yet another instance of value destruction. This is the company's balance sheet (at least some of which dates back to 2014 and is related to Brentwood's purchase):
That $91mm senior secured term loan? Yeah, that's where KKR sits.
The company has a commitment for a $28mm DIP credit facility from KeyBank which will effectively rollup the senior secured revolving loans and provide $8mm in new money.
The company has already filed a "hot potato" plan of reorganization — in other words, the lenders will take the company if they have to, but they don't really want to, and so they're happy to pass it on — and have a banker actively trying to pass it on (Lazard Middle Market) — to some other schmuck who thinks they can give it a go. In other words, similar to the plan proposed earlier this year in the Shopko case, this plan provides for the equitization of the allowed secured revolver and term loan claims IF the company is otherwise unable to find a buyer to take it off their hands and pay down some of their loans with cash. The company filed bid procedures along with the plan; it does not have a stalking horse bidder lined up. The company estimates a 4 month timeline to complete its bankruptcy.
We can't imagine that KKR is stoked to own this company going forward. And we can only imagine what kind of projections the company will put forth to convince the court that this thing is actually feasible: the plan has a blank space for the exit facility so that exit structure is also apparently a work in progress.
In any event, given recent loan underwriting standards, KKR, and other BDCs, might want to get used to owning credits they never expected to.
*Brentwood was represented in the transaction by Kirkland & Ellis LLP, now counsel to the company. The company drops in a footnote that any potential claims against Brentwood and its two directors will be conducted by Klehr Harrison Harvey Branzburg LLP, a firm we’re sure was hired with absolutely zero input by Kirkland and/or the two Brentwood directors. Two independent directors are currently sitting on the board.
Jurisdiction: District of Delaware (Judge: Laurie S. Silverstein)
Capital Structure: see above
Legal: Kirkland & Ellis LLP (Joshua Sussberg, Justin Bernbrock, Joshua Altman, Emily Kehoe) & (local) Klehr Harrison Harvey Branzburg LLP (Dominic Pacetti, Michael Yurkewicz)
Financial Advisor: Berkeley Research Group LLC (Mark Weinsten)
Investment Banker: Lazard Middle Market LLC (Jason Cohen)
Claims Agent: Bankruptcy Management Solutions, Inc. d/b/a/ Stretto (*click on the link above for free docket access)
Other Parties in Interest:
DIP Agent: Keybank NA
Legal: Buchanan Ingersoll & Rooney PC (Mary Caloway, Mark Pfeiffer)
KKR Credit Advisors US LLC
Legal: Proskauer Rose LLP (Vincent Indelicato, Christ Theodoridis) & (local) Morris Nichols Arsht & Tunnell LLP (Robert Dehney, Matthew Talmo)