⚡️Update: CBL & Associates Properties Inc.⚡️

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In our recent newsletter, “🇺🇸Forever 21: Living the (American) Dream🇺🇸,” we highlighted the exposure that landlords have to Forever21:

The company currently spends $450mm in annual rent, spread across 12.2mm total square feet. The company will close 178 stores in the US and 350 in total.

We highlighted how the company noted the impact this plan will have on large mall landlords, the company said:

Forever 21’s management team and its advisors worked with its largest landlords to right size its geographic footprint. Four landlords hold almost 50 percent of its lease portfolio. To date, Forever 21 and its landlords have engaged in productive negotiations but have not yet reached a resolution.

Two of those landlords were the largest unsecured creditors, Simon Property Group ($SPG) and Brookfield Property Partners ($BPY). But another, CBL & Associates Properties Inc. ($CBL), also has exposure. In “Thanos Snaps, Retail Disappears,” we discussed CBL’s issues: bankruptcy-related store closures are something that CBL is very familiar with. Management said last February that things were going to turn around but, instead, things just keep getting worse as more and more retailers go out of business.

Forever 21 is one of CBL’s top tenants, occupying 19 stores (plus 1 store in “redevelopment phase”). Per CBL’s FY 2018 10-K, Forever 21 accounts for roughly 1.2% of CBL’s revenue or $10 million.

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Of those 20 stores, 7 are subsumed by a motion by Forever 21 to enter into a consulting agreement to close stores (see bankruptcy docket (#81 Exhibit A):

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On October 14, 2019, partly due Forever 21’s bankruptcy, Moody’s downgraded CBL’s corporate family rating to B2 from Baa3 and revised its outlook to negative. Moody’s explained:

CBL's cushion on its bond covenant compliance is modest, particularly the debt service test, which requires consolidated income to debt service to annual debt service charge to be greater than 1.50x. The ratio has declined from 2.46x at year-end 2018 to 2.27x at Q1 2019, and 2.25x at Q2 2019 due principally to declining operating income during these periods. CBL's same-center NOI growth was -5.3% for Q2 2019 YTD and CBL projected same-center NOI growth to be between -7.75% and -6.25% for 2019, which means that the debt service test will likely weaken further.

The chart below reflects the company’s capital structure and debt prices. It is not doing well. In fact, the term loan and the unsecured notes have priced down considerably since March:

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Here is the company's stock performance:

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The last thing CBL needed — on the heals of the downgrade — was near-instantaneous bad news. It got it this week.

Yesterday, the bankruptcy court granted interim approval authorizing Destination Maternity Corporation ($DEST) to assume a consulting agreement with Gordon Brothers Retail Partners LLC. Gordon Brothers will be tasked with multiple phases of store closures. Among those implicated? CBL, of course:

CBL is landlord to DEST on 16 properties that are slated for rejection. Considering that DEST cops to being party to above-market leases, this ought to result in a real economic hit to CBL as (a) it will lose a high-paying tenant, (b) it will take time to replace those boxes, and (c) it is highly unlikely to obtain tenants at as favorable rents.

Let’s pour one out for CBL, folks. The hits just keep on coming.

🤪Lending, Lending, Lending🤪

Sunday’s looooooong special report, “CLO NO!?!?,” about Deluxe Entertainment, collateralized loan obligations (and their limitations), leveraged lending, EBITDA add-backs and other fun lending stuff sparked A LOT of interest. If you’re not a Member, you missed out and now thousands of people you’re competing with for business are officially smarter than you. Go you!

One thing we didn’t have time (or, given the length, space) to note is how private credit lenders take exception to being lumped in with the syndicated leveraged loan market and, by extension, CLOs. Indeed, “leveraged loans” are a rather broad category and there are differences between lenders that ought to be acknowledged: private credit vs. public BDCs vs. private BDCs vs. syndicating banks, etc., etc.

Regardless of distinctions, however, there’s clearly a ton of green out there looking for some action. To point, back in September, Bloomberg noted:

Globally, private credit, which includes distressed debt and venture financing, has ballooned from $42.4 billion in 2000 to $776.9 billion in 2018. By one estimate, the total is likely to top $1 trillion in 2020.

Public pension funds, insurance companies and family offices are some of the biggest investors putting money to work in private credit. Private equity firms themselves have also flooded into the space, forming their own credit arms or raising cash for private credit vehicles, along with private equity funds of funds from these investors. The frenzy has turned some lending start ups into heavyweights almost overnight. Owl Rock Capital Partners — a New York firm founded by BlackstoneKKR and Goldman Sachs veterans — has amassed $13.4 billion of assets since it started in 2016.

Bloomberg continued:

An influx of new lenders and fresh cash in the space has contributed to cutthroat competition and looser covenants -- terms lenders impose on borrowers to help protect their investments -- in addition to thinner returns. Regulators in Europe have taken note of private credit’s boom, saying its growth has been accompanied by signs of increased risk-takingUBS credit strategists have called private credit “ground zero” for concerns due to the increased leverage on direct loans. Covenants can also be undermined when borrowers goose their earnings by, for instance, claiming savings from ambitious cost-cutting programs that may never come to pass. Jamie Dimon, CEO of JPMorgan, has also said some non-bank lenders may not survive an economic slump because they’re holding lower-quality loans -- and their disappearance could leave some borrowers “stranded.”

Hmmm. It sure sounds like the aforementioned distinctions may be without a difference given the market dynamics.

In response, the private credit guys — and, yes, they’re overwhelmingly dudes — love to say that they’re not necessarily overrun by the supply/demand imbalance that generally exists elsewhere in credit. “We have proprietary credit analysis techniques,” they’ll say, thumping their vested chests in the process. “We have specialization in category XYZ,” they’ll argue in an attempt to de-commoditize themselves. Boasts notwithstanding, any actual or alleged competitive differentiation hasn’t, in fact, insulated most lenders from macro market trends where sponsors have the power and lenders capitulate on the regular. No doubt, private equity sponsors are playing competing BDCs and private credit providers against one another to get deals done with favorable terms. Otherwise, we wouldn’t be reading about EBITDA add-backs, and cov-lite or cov-loose, etc.

Still, they’re combative. “Credit quality is more important than documentation,” they’ll say, highlighting how they loan with the intent to satisfy the life cycle of the paper rather than dole it out or ditch it. Management. Industry. Financials. No cyclicality. The documentation is less relevant when these things line up, they’ll say. Do that right and they won’t have to worry about what happens when the thing goes sideways. Counterpoint: restructurings wouldn’t exist if underwriting was 100% bullet-proof.🤔 

Alternatively they’ll deploy the Trump defense. “Sure, sure, our docs suck. But the worst private credit doc is better than the best syndicated loan doc.” Or they’ll argue that they’re able to get favorable pricing in exchange for the lax nature of the docs. Maybe. We suppose we’ll also see in due time if that pricing properly compensates lenders for the risks they’re taking.

Look, we get that the type of loans that now constitute “private credit” fared relatively well in the last cycle. We also understand priority and acknowledge that top-of-the-capital-structure loans ought to be, from a recovery perspective, fine places to play. But to cavalierly play it like there isn’t reason for concern is disingenuous.

Apropos, Golub Capital just hired new Workout Counsel. He — and his ilk — may be busier than these private credit lenders care to admit.

💥CLO NO!?!?💥

On October 3rd, Deluxe Entertainment Services Group Inc., a content creation-to-distribution video services company (whatever the hell that means), filed a prepackaged bankruptcy case in the Southern District of New York. The purpose? To address the company’s over-levered capital structure ⬇️.

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That’s right, even “content creation-to-distribution video services” companies have no trouble loading up over $1b of debt.

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Gotta love these markets. Anyway, it’s not the capital structure itself that’s interesting here. Rather, it’s the parties playing in that capital structure.

In its bankruptcy papers, the company took pains to note that it thought it would get an out-of-court deal done. In July, it secured a loan — the $73mm “Priming Term Loan” above — to enhance liquidity and bridge the company to a transaction that would substantially reduce its debt obligations by equitizing the “Existing Term Loans.” Shortly thereafter, as all parties were working towards consummating the transaction, it became apparent to all that the company would need $25mm in incremental liquidity. While this is curious from a 13-week cash flow management perspective (), this shouldn’t have been a show stopper.

But then the ratings agencies had to go and screw everything up.

On August 5th, S&P Global Ratings downgraded the company’s debt three notches into junk territory to CCC- from B-. Per the Wall Street Journal:

S&P primary credit analyst Dylan Singh said the ratings were lowered because Deluxe has faced challenges in refinancing its debt structure, a problem that could increase the likelihood of a default.

Although the new $73 million loan will give additional liquidity to Deluxe, Mr. Singh said he doesn’t expect the company to be able to repay its ABL facility when it comes due in November and believes the business will try to extend the maturity before then. The current capital structure is unsustainable, he said.

Crossing over to the CCC threshold is a big problem for a lot of lenders — specifically, CLOs. For the uninitiated, here is a decent CLO primer about what CLOs are and how they work. For purposes of this briefing, it’s important to note that most CLOs are forbidden by their foundational fund docs from holding an allocation of more than 7.5% of their portfolio in CCC-or-lower-rated debt. This effectively handcuffed most of the CLOs in Deluxe’s capital structure from providing the necessary new money.


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⚡️Update: WeWork⚡️

This was us covering the hourly news diarrhea that came out about WeWork in the last 48 hours alone:

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Which, we suppose, is better than how the company’s equity and existing noteholders must be managing:

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Or the fine bankers over at JPMorgan Chase ($JPM) who are tasked with finding capital markets suckers…uh…investors…who’d be so kind as extend this steaming pile a lifeline:

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So, sifting through the constant headlines, where are we at?

Okay, right. The hot mess of a liquidity profile and limited amount of debt capacity to get a deal done.  Nothing to see here. All good.

Reminder: it is widely believed that WeWork will run out of cash by the end of the year without a new deal in place. Axios reports:

The company reported $2.4 billion of cash at the end of June, with a first-half net loss of $904 million. At that pace, it should have been able to survive at least through the middle of 2020. But I'm told that it significantly increased spend in Q3, partially due to the lumpy nature of real estate cap-ex, believing it would be absorbed by $9 billion in proceeds from the IPO and concurrent debt deal. One source says that there's probably enough money to get through Thanksgiving, but not to Christmas.

Riiiiiight. So here are the options:

  • Softbank Group new equity and debt bailout pursuant to which they get control of WeWork and napalm Masa’s former boy, Adam Neumann, in the process. This would reportedly be an aggregate $3b package “to get through the next year” — repeat, TO GET THROUGH THE NEXT YEAR — with the equity component coming significantly cheaper than the previous self-imposed $47b valuation (at a $10b valuation); or

  • JPM arranges some hodge-podge debt package and tests the market’s never-ceasing thirst for yield, baby, yield. The early reports were that the financing package would be $3b, comprised of $1 billion of 9-11% secured debt, $2b of unsecured PIK notes yielding 15% (1/3 cash pay, 2/3 PIK), and letter of credit availability. Wait, 15%?! How does a company with no liquidity even pay that? That’s why the PIK component is so critical: it would simply add 2/3 of the interest due to the principal of the debt. Said another way, the debt would compound annually and creep past $2.5b in two years. Per Bloomberg, “The $2 billion of proposed unsecured debt may carry an additional sweetener for investors: equity warrants designed so that investors could boost their return to around 30% if the company gets to a $20 billion valuation, according to the person who described the structure.” Because debt won’t dilute equity like Softbank’s equity-heavy proposal would, WeWork insiders (read: Neumann) apparently prefer the JPM approach. Regardless of what insiders prefer, however, is whether the market will be receptive to what one investor dubbed, per Bloomberg, “substantial career risk.

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We’re old enough to remember when WeWork’s notes rebounded a mere five days ago for reasons that were wildly inexplicable to us then and even more so now.

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So, to summarize, who are the big winners? IWG/Regus ($IWGFF)(long?). We’re pretty sure they’re loving what’s happening here; we have to imagine that the inbound calls have to be on the upswing. Also, the restructuring professionals. Whether you’re Weil Gotshal & Manges LLP (Softbank), Houlihan Lokey ($HLI)(Softbank), or Perella Weinberg Partners (WeWork’s Board of Directors), you’re incurring more billables/fees than you expected to mere days weeks ago. Somehow, some way, the restructuring pros always seem to come out ahead. And, finally, Goldman Sachs ($GS). Because there’s nothing more Goldman-y than them selling their prop stock right out from under a proposed IPO.

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💊How's GNC Doing (Long Online Supplements, Short Fitness Stores)?💊

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A quick recap of PETITION’s coverage of everyone’s (cough, no one’s) favorite supplements slinger.

In August 2017 in “GNC Holdings Inc. Needs Some Protein Powder,” we wrote:

GNC Holdings Inc. ($GNC) remains in focus as it reported its Q2 numbers this past Thursday. In summary, decreased consolidated revenue, decreased domestic (company-owned and franchised) same-store sales, decreased net income and operating income, decreased manufacturing/wholesale business...basically a hot mess. Limited bright spots included China sales and the new GNC storefront on Amazon. You read that right: the storefront on Amazon. Ugh. The company has $52mm of cash, $163.1mm available under its revolver and a robust $1.5b of long-term debt on its balance sheet. The stock traded down 7% after the announcement (but was up on the week).

In February 2018 in “GNC Makes Moves (Long Brand Equity, Meatheads & Chinese Cash),” we introduced the great strides GNC was undertaking to avoid a bankruptcy filing. These actions included (a) paying down its revolving credit facility, (b) moving towards an amend-and-extend transaction vis-a-vis its term loan, (c) obtaining a $300mm capital infusion by way of issuance of a perpetual preferred security to CITIC Capital, a Chinese investment fund and controlling shareholder of Harbin Pharmaceutical Group, and (d) the formation of a JV in China whereby it would slap its brand on Harbin’s product.

The following month in “GNC Holdings Inc. & the Rise of Supplements,” we highlighted that the amend-and-extend got done. And this:

Concurrently, the company entered into a new $100 million asset-backed loan due August 2022 and engaged in certain other capital structure machinations to obtain $275 million of asset-backed “first in, last out” term loans due December 2022. Textbook. Kicking. The. Can. Which, of course, helped the company avoid Vitamin World’s bankrupt fate.  Goldman Sachs!

We also noted a number of DTC supplements companies that were juiced by financings or acquisitions, citing them as headwinds to GNC and GNC’s nascent DTC business. The stock traded at $3.97/share back then. And we wrote:

Perhaps those restructuring professionals disappointed by Goldman Sachs’ success in securing the refinancing should just put that GNC file in a box labeled “2021.”

We revisited GNC in May 2018 in “GNC Holdings Inc. Isn’t Out of the Woods Yet.” At that time, the stock hovered around $3.53/share and the company reported more bad news including (i) 200 store closures, and (ii) declining revenue, same store sales at domestic franchise locations, and net income. We wrote:

Clearly GNC’s future — now that it has some balance sheet breathing room — will depend on its ability to capture new international markets, e-commerce growth primarily through its private label, innovation around product to combat DTC supplements brands, and continued cost controls. It will also need to execute on its goal of translating e-commerce sales to foot traffic. To accomplish this Herculean task, GNC may just need some supplements.

Last July, we noted that revenue continued its downward trend but earnings generally beat (uber-low) expectations. In August, we highlighted how Goldman Sachs was acting very “Goldman-y,” given that Goldman Sachs Investment Partners was a major investor in DTC vitamins and supplements startup Care/of, which had just raised a $29mm Series B round. We’ve slacked on our coverage since.

So, like, what’s up with GNC now?

It reported earnings back in July and continued to show weakness. Quarterly consolidated revenue and adjusted EBITDA declined meaningfully — the latter down 3% YOY. Same store sales were down 4.6%. E-commerce was down 0.2%. Revenue from franchise locations decreased 1.8%.

The company blamed promotional offers it implemented at the beginning of the quarter for the lousy same-store sales results.

Early in the second quarter, we made some adjustments to some of our promotional offers and our marketing vehicles, and we saw a direct negative impact to the top line. We quickly course corrected and saw sales strengthen throughout the remainder of the quarter.

PETITION Note: somebody must have gotten fired. Hard. Nothing like dropping an idea that is so horrifically bad that it immediately resulted in a “direct negative impact to the top line.” YIKES.

Speaking of yikes, mall performance is, like, YIIIIIIIIIIIKES:

In addition, the negative trends in traffic that we've seen in mall stores over the past several years has accelerated during the past few quarters putting additional pressure on comps. As part of our work to optimize our store footprint, we're increasing our focus on mall locations. And as you know, we have a great deal of flexibility to take further action here due to the short lease terms we have across our store portfolio.

It's important to note that our strip center locations are relatively stable from a comparable sales perspective. As a reminder, 61% of our existing store base is located in strip centers while only 28% reside in malls.

As a result of the current mall traffic trends, it's likely that we will end up closer to the top end of our original optimization estimate of 700 to 900 store closures.

Mall landlords everywhere were like:


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⚡️Update: What's Up With Francesca's ($FRAN)?⚡️

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We first wrote about Houston-based Francesca’s Holdings Corp. ($FRAN) back in February when (i) the stock was trading at $0.92/share, (ii) the company had announced that it had retained Rothschild & Co. and Alvarez & Marsal LLC, and (iii) the company was coming off of a quarter where it (a) reported -14% same store sales, -10% net sales, and a net loss of $16mm, (b) acknowledged that 17% of its retail footprint was “underperforming,” and (c) blew out its fifth CEO in seven years. That’s all.

A lot has transpired since then. Going into its second quarter ‘19 earnings, the stock — after declining 80% over the last year — was suddenly and mysteriously on a small August upswing, reaching as high as $5.16/share on September 9 (PETITION Note: the company did a mid-summer 12-for-1 reverse stock split so that mostly explains the recovery from the $0.92/share level we’d previously written about but the upswing continued thereafter).

Then some weird sh*t happened. The company issued earnings and comp store sales were down 5% and net sales decreased 6%. Gross margins were also down.

Here is a snapshot of the company’s sales growth / (decline) over the years:

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The company noted a decrease in margin’s due to aggressive markdowns, here are EBITDA margins over the last few years:

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Here is the overall performance over the years:

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And yet the stock popped on the report:

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That’s right. It got as high as $18.14/share on this report. We know what you’re thinking: “that report sucks, the numbers were terrible.” Yes, yes indeed, they were. But, on a relative basis, this marked a dramatic improvement.


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PG&E Picks Up the Pace (Long Seth Klarman)

 
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Well, that sure didn’t last long. In “Is it a Plan or a Placeholder?,” we discussed the recently proposed plan of reorganization filed by PG&E Corporation and Pacific Gas and Electric Company ($PCG). We wrote:

Moreover, the plan also depends on the “Subrogation Wildfire Claims” — claims “held by insurers or similar entities in connection with payments made to others on account of damages or losses arising from such wildfires” — coming in at a max $8.5b.[] Will these numbers hold? We suspect the answer is an emphatic ‘no.’

As much as we like being right, we certainly weren’t expecting it to happen so soon.

A mere few days after filing its plan of reorganization, PG&E announced an $11b settlement with parties representing 85% of the Subrogation Wildfire Claims. This settlement, still subject to the approval of the Bankruptcy Court, would satisfy and discharge all insurance subrogation claims against the Debtors arising from the 2017 Northern California wildfires and the 2018 Camp fire.” Per Reuters:

The company also amended its equity financing commitment agreements to accommodate the claims, and reaffirmed its $14 billion equity financing commitment target for its reorganization plan.

One amendment was an increase in the “Wildfire Claims Cap” to $18.9b from $17.9b. The debtors understand the signaling here: with the subrogation claimants almost immediately getting $2.5b more than what was in the plan, they prudently indexed higher to account for wildfire claimant expectations.

Despite the assumption of $3.5b more in liabilities (exclusive of earlier settlements), this is a net positive for PG&E. They removed one constituency from the board (assuming they don’t trade out of their claims and blow up the settlement), got a legitimate impaired accepting class to help usher the plan through, and moved themselves closer to a global settlement.

Anyway, the stock — somewhat mysteriously considering the marked INCREASE in liabilities — reacted favorably to the news, up over 11% on the week and erasing Monday’s post-plan blistering:

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⚡️What to Make of the Credit Cycle. Part 28. (Long Financial Ingenuity.)⚡️

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Nobody questions that we’re late stage at this point. Lest you have any doubt, consider the following:

1. Enhanced CLOs

Per The Wall Street Journal:

A growing number of money managers are embracing a new strategy designed to benefit from volatility in junk-rated corporate loans, a sign of building worries about riskier borrowers and the market that supports them.

Since November of last year, three different money managers have issued $1.6 billion of so-called enhanced collateralized loan obligations that are set up to hold a much larger amount of loans with extremely low credit ratings than typical CLOs. At least two more managers are expected to follow suit in the coming months.

The emergence of the enhanced CLOs underscores investors’ growing belief the U.S. economy is due for a recession after more than a decade of expansion. It also reflects particular concerns about corporate loans, starting with a decline in their average credit ratings. Since 2011, the amount of loans rated B or B-minus—just above near-rock bottom triple-C ratings—have ballooned to 39% of the market from 17%, according to LCD, a unit of S&P Global Market Intelligence.

CLOs are weird beasts with certain idiosyncratic limitations. As just one example, many CLOs are limited to a portfolio that includes no more than 7.5% of CCC-rated loans. Upon a rash of downgrades during a downturn, this would force these CLOs to sell their holdings, pushing supply into the markets and inevitably driving down loan prices. An opportunistic buyer could stand to benefit from this opportunity. These newly established CLOs won’t have these constraints; they could “stock up to half their portfolios with triple-C debt.

By way of example:

Investors say there is ample evidence that the limited ability of CLOs to hold triple-C loans creates unusual price moves in the $1.2 trillion leveraged loan market.

In one example, the price of a loan issued by the business-services company iQor Holdings Inc. dropped from around 98 cents on the dollar to 85 cents last summer immediately after Moody’s Investors Service and S&P Global Ratings downgraded the loan to triple-C. Data showed CLO holdings of the loan falling sharply at the time.

Ellington Management GroupZ Capital Group and HPS Investment Partners are the funds looking to take advantage of these market moves.

2. Retail CDOs

Ahhhhhh, Wall Street. JP Morgan Chase & Co. ($JPM) apparently wants to expand markets for credit derivatives, including synthetic CDOs. Per the International Financing Review:

The US bank launched its Credit Nexus platform earlier this year, according to a person familiar with the matter. The platform is designed to simplify the cumbersome process investors usually face to trade derivatives, including credit-default swaps, CDS options and synthetic collateralised debt obligations, according to a client presentation obtained by IFR.


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⚡️Update: Trickle-Down Healthcare Distress (Long Electronic Beds, Short Nana). Part I.⚡️

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We scoured far and wide to see whether there might be some businesses that would get hammered by the uptick in healthcare distress we’ve all witnessed of late. In early June, we took a bit of a stab in the dark (Members’-only access):

There has been notable bankruptcy activity in the healthcare industry this year — from continuing care retirement communities to the acute care space. When end users capitulate and need to streamline operations and cut costs, who gets harmed farther down the chain? It’s a good question: after all, there’s always some trickle down effect.

Our internal search for answers to this question recently brought us to Charlotte-based Joerns Healthcare, a “premier supplier and service provider in post-acute care.” The company sells supportive care beds, transport systems, respiratory care solutions and more.

Among other things, we noted how the Joerns’ term loan maturing May 2020 “was among one of the worst performing loans in the month of May — quoted in the low 70s, down approximately 15% since April.” We insinuated that a bankruptcy filing may not be too far away.

We didn’t expect it to be in court a mere six weeks later.

On Monday, Joerns WoundCo Holdings Inc. and 13 affiliated entities filed a prepackaged bankruptcy in the District of Delaware. Among other reasons provided to explain its capitulation into bankruptcy court is “post acute sector disruption.” Now that’s music to our ears.

Credit Default Swaps (Short Windstream’s Management, Puffery & Stupid F*cking Ideas)


Here
 is a late-to-the-party rant by William D. Cohan in the New York Times about the deleterious effect of credit default swaps and how they caused Windstream Holdings to file for bankruptcy. Here’s Cohan’s prescription to cure CDS ails:

What can be done about these perverse incentives? First, the Securities and Exchange Commission should immediately require greater disclosure of credit-default swap positions held by creditors. It’s the only way for a company, its investors and its employees to have a transparent understanding of a creditor’s motivations.

Ok, sure. What form would this disclosure take? How often would it have to be made? To whom should it be made? Is there a distinction to be made between CDS to hedge a debt position or naked CDS? So many questions.

He continues:

Once those positions are disclosed, the S.E.C. should help companies protect themselves from hostile creditors. The agency could, for example, allow companies to revise the terms of their bond agreements so that creditors with credit-default swaps don’t have the same voting rights as creditors who want a company to succeed. The definition of “failure to pay” and other conditions that might set off a default could also be revised to make it harder for a hedge fund to push a company into technical default. Judges can also play an important role, by taking the creditors’ motivations into account as more of these cases inevitably wind up in the courts.

What. The. F*ck.


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💥Sycamore Partners is a B.E.A.S.T. Part I.💥

🔥Rinse Wash & Repeat (Long Sycamore Partners)🔥

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Sycamore Partners is a private equity firm that specializes in retail and consumer investments; it “partner[s] with management teams to improve the operating profitability and strategic value of their businesses.” Back in the summer of 2017, Sycamore Partners acquired Massachusetts-based office retailer Staples Inc. for $6.9b — a premium to the company’s then-trading price but a significant discount from its 2014 high. Your office supplies, powered by private equity! The acquisition occurred shortly after Staples ran afoul of federal regulators who prevented Staples from acquiring Florida-based Office Depot Inc. ($ODP)(which, itself, appears to just trudge along).

Sycamore’s reported thesis revolved around Staples’ delivery unit, a B2B supplier of businesses. Accordingly, per Reuters:

Sycamore will be organizing Staples along three lines: its stronger delivery business, its weaker retail business and its business in Canada, two sources familiar with the deal said. This structure will give Sycamore the option to shed Staples’ retail business in the future, one of the sources said.

The retailer had 1255 US and 304 Canadian stores at the time of the deal. The business reportedly had 48% of the office supply market, generating $889mm of adjusted free cash flow in 2016.

*****

Fast forward 18 months and, Sycamore is already looking to take equity out of the company. According to Bloomberg, the plan is for Staples to issue $5.2b of new debt ($3.2b in term loans and $2b of other secured and unsecured debt), which will be used to take out an existing $3.25b ‘24 term loan and $1b of 8.5% ‘25 unsecured notes (which Sycamore reportedly owns roughly $71mm or 7% of).* This is textbook Sycamore, so much so that it’s actually cliche AF — or as Dan Primack said, “…this sort of myopic greed gives ammunition to private equity’s critics.” Like this guy:

And this gal:

Talk about reputations preceding…

Anyway, here’s what the deal would look like once consummated:

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That $1b difference is the equity that Sycamore is taking out of the company. What does the company get in return? F*ck all, that’s what. Zip. Zero. Dan Primack also wrote:

Dividend recaps are a mechanism whereby private equity-owned companies issue new debt, and then hand proceeds over to the private equity firm (as opposed to using it to grow the business). Sometimes they don't matter too much. Sometimes they form leveraged anchors around a company's neck. (emphasis added)

Yup. That about sums it up. Here is Sycamore placing a leveraged anchor on…uh…improving “the strategic value” of Staples:

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This is the market reacting to Sycamore’s strategy for Staples:

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If the above GIF looks familiar, that’s because this is like the Taken series: Sycamore has a very particular set of skills. Skills it has acquired over a very long run. Skills that make them a nightmare for retailers like Staples. They look poised to deploy those particular skills over the course of a repetitive trilogy: the first chapter centered around Aeropostale. And here’s how that ended:

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The sequel was Nine West and this is how that ended:

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And, well, you get the point. Staples looks like it may be next to experience those very particular skills.

———

Okay, so the above was a bit unfair. In Aeropostale, the company went after Sycamore Partners hard, seeking to ding Sycamore, among others, for equitable subordination and recharacterization of their (secured) claims. Why? Well, Sycamore was not only the company’s term lender (to the tune of $150mm), but it was also a major equity holder with 2 board seats and the majority-owner of Aeropostale’s largest (if not, second largest) merchandise sourcer and supplier, MGF Sourcing Holdings Ltd.

NERD ALERT: for the uninitiated, equitable subordination is an equitable remedy that a bankruptcy court may apply to render justice or right some unfairness alleged by a debtor (or some other party in the shoes of the debtor, if applicable). It is generally VERY DIFFICULT TO WIN on this argument because the burden of proof is on the movant and there are multiple factors and subfactors that the accuser needs to satisfy — because, like, this is the law and so everything has a test, a sub-test, and a sub-sub-test and maybe even a sub-sub-sub-test. Judges love tests, sub-tests, and multi-pronged sub-tests. Three-prongs. Four-prongs. Everywhere a prong prong. Just take our word for it. It’s true.

Recharacterization is another equitable remedy that, if satisfied and granted by the court, would have resulted in Sycamore’s $150mm secured term loan position being reclassified as equity. This is a big deal. This would be like Mike Trout being on the verge of winning the MVP and the World Series AND securing a $350mm 10-year contract only to, on the eve of all of that, get (a) caught partying with R. Kelly til six in the morning with enough PED needles lodged in his butt to kill a team of horses, (b) suspended from baseball, (c) exiled into an early retirement a la Alex Rodriguez or Barry Bonds, and (d) forced into personal bankruptcy like Latrell Sprewell or Antoine Walker. Or, more technically stated, since secured debt is way higher in “absolute priority” than equity, this would instantaneously render Sycamore’s position worthless and juice the potential recovery of unsecured creditors. Then there is the practical side: for this remedy to apply, the bankruptcy court would have to make a “finding” that prong after prong has been satisfied and issue an order saying you’re the shadiest m*therf*cker on the planet because you’re actually dumb and careless enough to have met all of the prongs. So, as you might imagine, this is pretty much the worst case scenario for any secured party in bankruptcy and a career ender for the poor schmo who orchestrated the whole thing.

In Aeropostale, the Debtors argued that Sycamore and its proxy MGF engaged in inequitable conduct prior to Aeropostale’s filing, including (a) breach of contract, (b) “a secret and improper plan to buy Aeropostale at a discount” and (c) improper stock trading while in possession of material non-public information. This one had the added drama of arch enemies Kirkland & Ellis LLP (Sycamore) and Weil Gotshal & Manges LLP (Aeropostale) duking it out to the ego-extreme. Just kidding: this was all about justice! 😜

Anyway, there was a trial with fourteen testifying witnesses over eight presumably PAINFUL days that, in a nutshell, went like this:

WEIL GOTSHAL: “Sycamore are a bunch of conspiratorial PE scumbags who ran this company into the ground, your Honor!

JUDGE LANE: “Not credible. Good day, sir. I said GOOD DAY!

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KIRKLAND & ELLIS/SYCAMORE:

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In the end, Sycamore fared pretty well. They got nearly a full recovery** and releases under the plan of reorganization. Relatively speaking, the company also fared well. It didn’t liquidate.*** Instead, two members of the official committee of unsecured creditors — GGP and Simon Property Group ($SPG)— formed a joint venture with Authentic Brands Group and some liquidators and roughly 5/8 of the stores survived — albeit as a shell of its former self and with heaps of job loss (improved strategic value!!). Sure, millions of dollars were spent pursuing losing claims but that’s exactly the point: when Sycamore is involved, they win**** and others lose.***** The extent of the loss is just a matter of degree.

———

Speaking of degrees, all the while Nine West was lurking in the shadows all like:

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WHOA. BOY. THIS ONE WAS A COMPLETE. AND UTTER. NEXT LEVEL. SH*TSHOW.

We’ve discussed Nine West at length in the past. In fact, it won our 2018 Deal of the Year! We suggest you refresh your recollection why (including the links within): it’s worth it. But what was the end result? We’ll discuss that and the (impressively) savage tactics deployed by Sycamore Partners therein in Part II, coming soon to an email inbox near you.

*At the time of this writing, the unsecured bonds last traded at $108.01 according to TRACE. This potentially gives Sycamore the added benefit of booking significant gains on the $71mm of unsecured notes in its portfolio.

**It’s unclear whether Sycamore recovered 100% but given that they got $130mm under the cash collateral order out of an approximately $160mm claim, it’s likely to have been close. Now, they did lose $53mm on AERO stock.

***A f*cking low bar, sure, but still. Have you seen what’s happening in these other retail cases?

****Putting aside nation-wide destruction, hard to blame LPs for investing in the fund. They get returns. Plain and simple. This ain’t ESG investing, people.

*****Sure, Weil “lost” its attempt to nail Kirkland…uh Sycamore…here but they got paid $15.3mm post-petition and $4.4mm pre-petition so that’s probably the best damn consolation prize we’ve ever heard of in the history of mankind. Weil has, to date, also avoided having a chapter 22 and liquidation in its stable of quals so there’s that too. In retail, you have to take the victories where you can get them.

GAIN THAT EXTRA EDGE WITH PETITION, SUBSCRIBE TO OUR KICKA$$ PREMIUM NEWSLETTER HERE.

💸Goldman Sachs Hops Aboard the Mall Short💸

Mall Shorts Gather Steam

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In last Wednesday’s “Thanos Snaps, Retail Disappears👿,” we included a LOOOOOONG list of retailers that are shutting down stores. Subsequently, J.Crew Group announced that it is closing a net 10 stores (20 J.Crew locations offset by 10 Madewell openings), Williams-Sonoma Inc. ($WSM) announced that it plans to close a net total of 30 stores, Hibbett Sports Inc. ($HIBB) announced approximately 95 stores will close this year, and Tommy Hilfiger closed its global flagship store on Fifth Avenue (Query: is New York City f*cked?) and its Collins Avenue store in Miami.

The point of the piece, however, wasn’t to wallow in retail carnage: rather, it was to make the point that there’s no way the malls — or at least certain malls — could continue business as usual.* With thousands of stores coming offline, we argued, there have to be malls that start feeling the pain and, eventually, run afoul of their lenders. We used $CBL as our poster child and closed by stating that Canyon Partners was shorting mall-focused CMBS via a CDS index, the Markit CMBX.BBB- (and lower indices).

Apparently Goldman Sachs Inc. ($GS) is in on the action. Late last week, Goldman urgedclients join the "big short" bandwagon by going short CMBX AAA bonds (while hedging in a pair trade by going long five-year investment-grade corporate CDX).” ZeroHedgesummarizes the Goldman report as follows:

Citing the bank's recent review of potential areas of financial imbalance across the US corporate and household sectors, [the Goldman analyst] notes that stretched CRE valuations ranked near the top in terms of risk level; and while a large and immediate commercial property price downturn is not the bank's baseline forecast, "a scenario with falling commercial property prices in the next 1-2 years is one to which we would attach non-negligible probability" the analysts caution.

And, then, in customary hyperbolic form, Zerohedge concludes:

Why is this notable? Because regular readers will recall that the 2007/2008 financial crisis really kicked in only after Goldman's prop desk started aggressively shorting various RMBS tranches, both cash and synthetic, in late 2006 and into 2007 and 2008, with the trade eventually becoming the "big short" that was popularized in the Michael Lewis book.

Will Goldman's reco to short CMBX-6 AAA be the trigger that collapses the house of cards for the second time in a row? While traditionally lightning never strikes twice the same place, the centrally-planned market is now so broken that even conventional idioms have to be redone when it comes to the world's (still) most important trading desk. In any case, keep an eye on commercial real estate prices: while residential markets have already peaked with most MSAs sliding fast, commercial may just be the first domino to drop that unleashes a tsunami of disastrous consequences across the rest of the market.

It is far from certain that all of this noise about shorting CMBS is anything more than isolated trades. One thing that is certain? Zerohedge is better at drumming up fear than Jordan Peele.

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*****

Speaking of J.Crew, S&P took a dump all over it yesterday as it downgraded the issuer credit rating to CCC and simultaneously downgraded its “intellectual property notes” — ouch, that must sting some (short asset stripping?) — and its secured term loan facility. The ratings agency maintains a “negative outlook” on the company, saying that “operating results deteriorated considerably in the most recent quarter,” and “approaching maturities of the company’s very high debt burden could lead J.Crew to restructure its debt in the next 12 months.” S&P provides a damning assessment:

We think the company continues to face significant headwinds to turn around operations which haven’t meaningfully improved since the J Crew brand relaunch in 2018. These threats include fast fashion and online retail, as well as continued declines in mall traffic and greater price transparency across the apparel industry. We believe these trends are especially heightened for U.S. mid-priced apparel retail players as consumers shift apparel spending toward brands with a consistent customer message or more appealing prices, given the continued preference for value, freshness, and convenience.

Tell us how you really feel, S&P.

*****

Speaking of damning assessments, there was this flamethrower of a press release issued by Legion Partners Holdings LLC, Macellum Advisors GP LLC, and Ancora Advisors LLC regarding Bed Bath & Beyond Inc. ($BBBY). Burn, baby, burn.

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PETITION readers will recall our previous discussion of BBBY. In January in “Is Pier 1 on the Ropes? (Short “Iconic” Brands),” we included discussion of BBBY and declared:

Bed Bath & Beyond swam against the retail tide last week as the company’s stock showed huge gains after it said that it is ahead of its long-term plan and that it is successfully slowing down declines in operating profit and net earnings per share. Which is interesting because, putting forward guidance aside, the ACTUAL numbers weren’t all that great. In fact, the company’s trend of disappointing same-store sales continues unabated (negative 1.8%, worse than forecast). EPS and revenue numbers were slightly better and slightly worse, respectively, than expected. Which means that to drive the higher EPS, the company must be taking costs out of the business. We have no crystal ball and this is in now way meant to be construed as investment advice, but we’re not seeing justification for a massive stock price increase (up 15% from when we wrote about it and 30% from its December 24 low).

Suffice it to say, the aforementioned investors were far from impressed. The press release kicks off with:

Magnitude of value destruction necessitates wholesale board and leadership changes. CEO Steven Temares has overseen the destruction of more than $8 billion in market value over his 15-year tenure, with total shareholder returns of negative 58%. Since early 2015, the stock has lost over 80% of its value.

Certainly not mincing words there, that’s for sure.

It then follows with:

Failed retail execution and strategy. Apparent inability to prioritize a long list of poorly implemented initiatives and management’s lack of success in adapting its business model to a changing retail landscape, has resulted in stagnant sales and adjusted EBITDA margins declining from 18% in fiscal 2012 to 7% in the last 12-month period ending November 2018.

Deeply entrenched board lacking retail experience is an impediment to serving shareholder interests. Average director tenure is approximately 19 years and the lack of retail expertise and stale perspectives on the board have hindered proper oversight of the management team.

We mean…those are just cold. Hard. Facts. And they’re not wrong about the board: it strains credulity to think that the Head of the TIAA Institute, a pensioned partner at Proskauer Rose LLP, and an EVP for Verizon Communications Inc. know f*ck all about the travails afflicting retail these days (to be fair: it seems the founder and CEO of Red Antler, a reputable branding agency that has helped build the likes of Casper, Keeps, Boxed, Google, allbirds and Birchbox makes sense…if anything has value here…and, yes, we’re REALLY stretching here…its the, gulp, brand…like, maybe??…or, like, maybe not???).

Seriously, it’s not really difficult to argue with this (even if the investors take some liberties in defining companies like Restoration Hardware ($RH) as “retail peers”):

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Problematically, however, the three firms own merely 5% of the outstanding common stock so there’s not a ton that they can do to agitate for change. The market, though, doesn’t seem to give a sh*t: it just wants something…anything…to happen with this business.

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More significantly, investors simply cannot sit on the sidelines anymore and watch retail management teams flail in the wind. We discussed certain management teams that really seem to be skating to where the puck is going, see, e.g., $PLCE. But many others aren’t and those that aren’t act at their own peril. Here, at least, investors are putting management and the board of directors on notice.

Expect to see other investors act similarly in other cases.

*There are a number of malls, however, that do seem to be continuing business as usual. This piece makes the point that apocalypse is not as bad as the media makes out.

💤Sears 💤

Eddie Lampert, ESL & Shenanigans

BREAKING NEWS: SHORT SEARS HOLDING CORP.

We’re old enough to remember when Sears Holding Corp. ($SHLD) was last rumored to file for bankruptcy. In 2017. 2016. 2015. 2014. 2013. 2012. 2011. And 2010 (the last year it turned a profit). This thing is like “Karl” in Die Hard.

Or this lady:

It just won’t die.

So this week’s reports that Sears’ CEO Eddie Lampert “Urges Immediate Action to Stave Off Bankruptcy” were met with, shall we say, a collective yawn. Lampert has been performing financial sleight-of-hand for years, all the while the five-year SHLD stock chart looks like this:

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This is what the Twitterati had to say about this: [ ].

Yes, that blank space is intentional. We’ve never seen Twitter so quiet. Grandma was like, “Sears? Sears? I last shopped in Sears when I was prom shopping…in 1956.” Mom was like, “I once bought you a Barbie at Sears…in 1989.” Some millennial somewhere was probably like, “Sears? What’s a Sears, brah?”

Just kidding: nobody is talking about Sears. That would imply mindshare. 🔥

Lack of mindshare notwithstanding, the company, despite a wave of closures over the years (including 46 unprofitable stores slated for closure in November ‘18), consists of 820 stores (including KMart). As of 2017, the company had 140,000 employees. Thats Toys R Usx 4.5. The company also has approximately $5.5 billion of debt, $1.1 billion of pension and post-retirement benefits, declining revenues, negative (yet improving) same store sales percentages, negative gross margin, and increasing net losses.

Source: SHLD Q2 Earnings Release Presentation, September 13, 2018

Source: SHLD Q2 Earnings Release Presentation, September 13, 2018

It also had $941mm of cash available as of the end of Q2 2018.

On Sunday, Lampert filed a Schedule 13D with the SEC outlining his proposal to save Sears in advance of a $134 debt payment due on October 15. High level, the proposal was…

“…to the Board requesting Holdings to consider liability management transactions, real estate transactions and asset sales intended to extend near-term debt maturities, reduce long-term debt, eliminate associated cash interest obligations and obtain additional liquidity.”

The proposed liability management transactions…provide for exchange offers to eligible holders of second lien debt…and eligible holders of unsecured debt…. These potential exchange offers together could save Holdings approximately $33 million per year in cash interest and eliminate approximately $1.1 billion in debt.

More specifically, the proposal calls for, among other options, ‘19 and ‘20 second lien debtholders and ‘19 unsecured noteholders to swap into zero-coupon mandatorily convertible secured debt (no yield, baby?)(read the 13D link above for more detail). It also calls for the sale of $3.25 billion worth of real estate and assets, including Sears Home Services and Kenmore.

After all of this time, why now? Per Bloomberg:

Lampert and ESL acted after watching other retailers including Toys “R” Us Inc. and Bon-Ton Stores Inc. wind up in liquidation, according to people with knowledge of the plan. The aim is to get something done out of court to preserve value for shareholders, since they don’t usually fare well in bankruptcy proceedings, said the people, who weren’t authorized to comment publicly and asked not to be identified.

There’s something strangely poetic about Lampert and ESL using the ghosts of Toys R Us and BonTon past to coerce creditors into an exchange transaction now.

Anyway, Twitter may have been quiet, but naysayers abound.

From Bloomberg:

“It seems the next natural iteration of all the financial engineering the company has been engaging in over the last few years,” Bloomberg Intelligence analyst Noel Hebert said. “For non-bank creditors not named Eddie Lampert, there is a bit of prisoner’s dilemma -- maybe something more tomorrow, or the near certainty of very little today.”

“This is simply storing up trouble for the future,” according to a note from Neil Saunders, managing director of research firm GlobalData Retail. “Sears is focusing on financial maneuvers and missing the wider point that sales remain on a downward trajectory,” he wrote. “Even in a strong consumer economy, customers are still drifting away to other brands and retailers.”

From the Washington Post:

“Eddie Lampert is seeking permission from himself to keep Sears on life-support while he continues to drain every last remaining drop of blood from its corpse,” said Mark Cohen, director of retail studies at Columbia Business School and the former chief executive of Sears Canada. “The operation is a failure, and there is no plan to turn that around."

From the Wall Street Journal:

“Given Lampert’s shuffling of Sears assets in ways some creditors suspect was more to his benefit than theirs, there is a chance they will hesitate to let him reorganize unless it is under the watchful eye of a bankruptcy judge,” said Erik Gordon, a University of Michigan business school professor.

Ugh. Wake us up when its finally over. Even Karl eventually died.


PETITION provides analysis and commentary about restructuring and bankruptcy. We discuss disruption, from the vantage point of the disrupted. Get our Members’-only a$$-kicking newsletter by subscribing here.

More Shenanigans in Retail: Neiman Marcus Edition

Retail Schmetail (Long Shenanigans; Long Litigation-Based Investment)

Just when retail was starting to get boring, Neiman Marcus stepped up this week to provide some real entertainment for bond investors. Thanks Neiman Marcus!

First, lending an additional boost the now-popular narrative that the "#retailapocalypse story is over, the luxury department store retailer reported earnings on September 18 that reflected (i) a 2.3% increase in quarterly revenue YOY, (ii) a dramatically reduced Q4 net loss on a YOY basis, and (iii) an increase in adjusted EBITDA. For fiscal year 2018, it reported total revenues of $4.9 billion, a 4.9% increase YOY. Free cash flow was $122.6mm vs. negative $57.7mm last year. Online revenues were up 12.5% for the quarter and accounted for 35% of the overall business.

And that last bit is where the rubber meets the road. At the tail end of its press release, Neiman slipped in this doozy like a slickster:

Subsequent to the end of the fourth quarter, the Company effected an organizational change as a result of which the entities through which the Company operates the MyTheresa business now sit directly under Neiman Marcus Group, Inc., the Company’s ultimate parent entity. These entities were unrestricted, non-guarantor subsidiaries under the Company’s debt instruments. As a result of this change, going forward the financial results of the MyTheresa entities will no longer be included in the Company’s publicly reported financial statements. The change is not expected to meaningfully affect operations for Neiman Marcus or MyTheresa.

Indeed, the company’s term loan and bonds — part of its $4.7 billion debt stack — did trade down but it wasn’t due to misplaced optimism. Rather, it was more likely attributable to the fact that the company, in a Petsmart-PTSD-inducing maneuver, just significantly weakened the bondholder collateral package.

Per the Wall Street Journal:

Before the transfer of MyTheresa to the parent company, Neiman Marcus Group Inc., there was some anticipation that the retailer would use the MyTheresa shares to entice bondholders to swap their debt for bonds with a longer maturity.

“Some bondholders may have incorrectly assumed that the company would embark on a distressed debt exchange involving MyTheresa shares as collateral,” said Steven Ruggiero, an analyst at Pressprich & Co.

It appears so.

James Goldstein, a retail analyst at CreditSights, noted that proceeds from any sale could now go directly to the investment companies that control the Neiman parent company, with bondholders likely having no claim. The parent company is owned by Ares Management LP and the Canada Pension Plan Investment Board.

“MyTheresa was already in an unrestricted subsidiary, but the way it’s structured now proceeds of any sale of MyTheresa goes straight to sponsors’ pockets without having to deal with the bondholders,” Mr. Goldstein said.

For now, this is a (potential) win for pensioners and a loss for hedge funds holding the debt. And one such hedge fund was, shall we say, a wee bit nonplussed. On Friday September 21, Marble Ridge Capital LP sent a letter to the company’s board of directors (and subsequently issued a very public press release about said letter) stating:

"…what these transactions appear to be is an attempt to move the MyTheresa business beyond the reach of existing creditors sitting between the sponsors' equity and the valuable MyTheresa assets. Most troubling, we understand that Ares and CPPIB usurped this massive benefit and took the MyTheresa business for no consideration."

"Marble Ridge has reason to believe that the Company was insolvent at the time of the Transactions or was rendered insolvent thereby. The Company is the issuer and/or guarantor of at least $4.7 billion of indebtedness. Based on LTM EBITDA of $478.2 million, the Company's indebtedness prior to the Transactions implies nearly a 10x leverage multiple (far in excess of any of its peers). Moreover, a dividend or other form of a spinoff by an insolvent guarantor to its equity sponsors, for no consideration, has all the hallmarks of an intentional or constructive fraudulent transfer (or illegal dividend) and raises serious questions of breaches of duties of care and loyalty, with exposure for Ares and CPPIB, as controlling shareholders, and for the Company's board. As noted above, Marble Ridge also has concerns that the Transactions do not comply with the Indentures."

The Wall Street Journal had previously reported that:

Neiman Marcus hired Lazard Ltd. and Kirkland & Ellis last year for advice on how to restructure its debt.

Looks like they deployed some of that advice.

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.

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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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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Distressed Debt Funds Fundraise (Long Market Timing)

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

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

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

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

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

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

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

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