Trickle-Down Healthcare Distress (Long Electronic Beds, Short Nana).

Nana’s Post-Acute Care, Powered by Private Equity.

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.

Now, all of that sounds well and good and even with operational and budgetary issues and rising healthcare costs, one could be forgiven for thinking that a business like this might be insulated to some degree — especially as baby boomers get older. Healthcare is not something people tend to skimp on. Yet, that simplistic thinking fails to take private equity into account. That’s right: your Nana’s post-acute care, powered by private equity.


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☁︎More Dark Clouds (Short Debt-Fueled Acquisition Sprees)☁︎

TierPoint LLC Gets a Beat Down from Moody’s

In “⛈A Dark "Cloud" on the Horizon⛈,” we noted, in the context of Fusion Connect Inc’s recent troubles ($FSNN), that not all cloud businesses are created equal. This week, another cloud-company, TierPoint LLC, came into view after Moody’s changed the company’s outlook to negative from stable. The private, Missouri-based company provides “colocation, cloud computing, backup and business continuity, managed security, firewall, and professional services,” creating an “Infrastructure-as-a-Service” stack for its customers in the education, energy, financial, healthcare, legal, manufacturing, retail and tech industries.

The company has been on an acquisition spree over the years, gobbling up data center company, Cosentry, data services provider, AlteredScale, and the data services business of Windstream Holdings in 2016. The company, by virtue of the Consentry deal, is a TA Associates Management LP portfolio company.

As you might imagine, with great acquisition sprees come great loads of debt. The company’s balance sheet sports a $700mm first lien term loan, a $220mm first lien revolver and a $220mm second lien term loan. Moody’s points to near-term challenges that might affect the company’s ability to delever including, among other things, “unexpected customer churn volatility in late 2017” proving difficult to overcome. Moreover, margins and growth are down, further complicating efforts to drive the debt leverage down — yes, down — to 7x.

🐶Petsmart Gets its Deal🐶

DON’T. MESS. WITH. DAISY. CHAPTER 5. (LONG ASSET STRIPPING AND COERCIVE CONSENT SOLICITATIONS).

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It's a beautiful day. You're walking down the street with your cute little puppy, Bacca, enjoying some much-needed serenity. The wind is blowing your hair back and the smell of flowers permeates the air. Life is good. You’re happy. Maybe you'll treat sweet lil' Bacca to some of that sweet organic sh*t today; after all, you're only a short walk to the local pet store. But then your phone rings.

"Bro. We need to make a decision."

"About what?" you ask, your chill vibes violently crushed by the voice of your excited junior analyst.

"PetSmart. They're doing an exchange. And it's coercive AF!"

Frikken Petsmart. You look down at Bacca and you swear you see a grimace on his cute little face as he stares back at you. You refocus your attention on your analyst, "Alright dude. Relax. What's the story?"

"Arnold & Porter Kaye Scholer is hosting an all hands term lender call soon. At issue is whether the group of term lenders will, in exchange for some enhanced economics, amend the credit docs governing the loan to post facto bless the company's absurd Chewy.com dividend." 

You reflect a bit on Petsmart as you continue your walk. Nearly exactly two years ago the company announced its whopper of a $3.35b Chewy.com transaction; it took on massive amounts of debt to fund the deal. It was the largest e-commerce acquisition ever — topping Walmart Inc’s acquisition of Jet.com. Venture capitalists instantaneously made a boatload of money (the pre-acquisition funding topped out at $451mm) but immediately the Petsmart capital structure looked wobbly after a two-part debt offering of (a) $1.35 billion of ‘25 8.875% senior secured notes and (b) $650 million of ‘25 5.875% unsecured notes. Rounding out the capital structure was a $750 million ABL, a $4.3 billion cov-lite first-lien term loan and $1.9 billion of cov-lite ‘23 senior unsecured notes. The company’s leverage ratio was approximately 8.5x.

You then reflect on June 2018. You recall reading this in PETITION:

WANT TO SEE WHAT YOU WISH YOU HAD READ MONTHS AGO? CLICK HERE AND REMEMBER MORE.

💥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.

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Cracks in Malls Grow Deeper (Long Thanos, Short CMBS)

Retail Carnage Continues Unabated (R.I.P. Payless, Gymboree, Charlotte Russe & Shopko)

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Talk of retail’s demise is so pervasive that the casual consumer may be immune to it at this point. Yeah, yeah, stores are closing and e-commerce is taking a greater share of the retail pie but what of it?

Well, it just keeps getting worse.

Consider 2019 alone. The Payless ShoeSourceGymboreeCharlotte Russe, Shopko, and Samuels Jewelers* liquidations constitute thousands of stores evaporated from existence. It’s like Thanos came to Earth and snapped his fingers and — POOF! — a good portion of America’s sh*tty unnecessary retail dissipated into dust. Tack on bankruptcy-related closures for Things RememberedBeauty Brands and Diesel Brands USA Inc. and you’re up to over 4,300 stores that have peaced out.

That, suffice it to say, would be horrific enough on its own. But “healthy” (read: non-bankrupt) retailers have only added to the #retailapocalypse. Newell Brands Inc. ($NWL)is closing 100 of its Yankee Candle locations to focus on “more profitable” distribution channels. Gap Inc. ($GPS) announced it is closing 230 of its more unprofitable locations and spinning Old Navy out into its own separate company — the good ol’ “good retail, bad retail” spinoff. Chico’s FAS Inc. ($CHS) is closing 250 stores. Stage Stores Inc. ($SSI) — which purchased once-bankruptcy Gordmans — is closing between 40-60 department stores. Kitchen Collection ($HBB) is closing 25-30 stores. E.L.F. Beauty ($ELF) is closing all 22 of its locations. Abercrombie & Fitch Co. ($ANF)? Yup, closing stores. Up to 40 of them. GNC Inc. ($GNC) intends to close hundreds more stores over the next three years. Foot Locker Inc. ($FL)? Despite a strong earnings report, it is closing a net 85 stores. J.C. Penney Inc. ($JCP)…well…it didn’t report strong earnings and, not-so-shockingly, it, too, is closing approximately 27 stores this year. Victoria’s Secret ($LB)? 53 stores. Signet Jewelers Ltd. ($SIG)? Mmmm hmmm…it’s been closing its Zales and Kay Jewelers stores for years and will continue to do so. As we noted on SundayThe Children’s Place Inc. ($PLCE) also intends to close 40-45 stores this year. Build-A-Bear Workshop Inc. ($BBW) will close 30 stores over the next two years. Ascena Retail Group Inc. ($ASNA) recently reported and disclosed that it had closed 110 stores (2% of its MASSIVE footprint) in the last quarter. Even the creepy-a$$ dolls at American Girl aren’t moving off the shelves fast enough: Mattel Inc. ($MAT) indicated that it needs to rationalize its retail footprint. There’s nothing Wonder Woman — or even a nightmare-inducing American Girl version of Wonder Woman — can do to prevent all of this carnage.

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As a cherry on top, EVEN FRIKKEN AMAZON INC. ($AMZN) IS CLOSING ALL 87 OF ITS POP-UP SHOPS! Alas, The Financial Times pinned the total store closure number for 2019 alone at 4,800 stores (and just wait until Pier 1 hits). Attached to that, of course, is job loss at a pretty solid clip:

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All of this begs the question: if there are so many store closures, are the landlords feeling it?

In part, surprisingly, the number appears to be ‘no.’ Per the FT:

“Investors in mall debt have also shown little sign of worry. The so-called CMBX 6 index — which tracks the performance of securitised commercial property loans with a concentration in retail — is up 4.4 per cent for 2019.”

Yet, in pockets, the answer also appears to be increasingly ‘maybe?’

For example, take a look at CBL & Associates Properties Inc. ($CBL) — a REIT that has exposure to a number of the names delineated above.

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On its February 8th earnings call, the company stated:

“We are pleased to deliver results in line with expectations set forth at the beginning of the year notwithstanding the challenges that materialized.”

Translation: “we are pleased to merely fall in line with rock bottom expectations given all of the challenges that materialized and could have made sh*t FAR FAR WORSE.

The company reported a 4.4% net operating income decline for the quarter and a 6% same-center net operating income decline for the year. The company is performing triage and eliminating short-term pressure: it secured a new $1.185b ‘23 secured revolver and term loan with 16 banks as part of the syndicate (nothing like spreading the risk) to refinance out unsecured debt (encumbering the majority of its ‘A Mall’ properties and priming the rest of its capital structure in the process); it completed $100mm of gross dispositions plus another $160mm in “sales” of its Cary Towne Center and Acadiana Mall; it reduced its dividend (which, for investors in REITs, is a huge slap in the face); and it also engaged in “effective management of expenses” which means that they’re taking costs out of the business to make the bottom line look prettier.

Given the current state of affairs, triage should continue to remain a focus:

“Between the bankruptcy filings of Bon-Ton and Sears, we have more than 40 anchor closures.”

“…rent loss from anchor closures as well as rent reductions and store closures related to bankrupt or struggling shop tenants is having a significant near-term impact to our income stream.”

They went on further to say:

“Bankruptcy-related store closures impacted fourth quarter mall occupancy by approximately 70 basis points or 128,000 square feet. Occupancy for the first quarter will be impacted by a few recent bankruptcy filings. Gymboree announced liquidation of their namesake brand and Crazy 8 stores. We have approximately 45 locations with 106,000 square feet closing.”

Wait. It keeps going:

We also have 13 Charlotte Russe stores that will close as part of their filing earlier this month, representing 82,000 square feet.

Earlier this week, Things Remembered filed. We anticipate closing most of their 32 locations in our portfolio comprising approximately 39,000 square feet.”

And yet occupancy is rising. The quality of the occupancy, however — on an average rental basis — is on the decline. The company indicated that new and renewal leases averaged a rent decline of 9.1%. With respect to this, the company states:

As we've seen throughout the years, certain retailers with persistent sales declines have pressured renewal spreads. We had 17 Ascena deals and 2 deals with Express this quarter that contributed 550 basis points to the overall decline on renewal leases. We anticipate negative spreads in the near term but are optimistic that the positive sales trends in 2018 will lead to improved lease negotiations with this year.

Ahhhhh…more misplaced optimism in retail (callback to this bit about Leslie Wexner). As a counter-balance, however, there is some level of realism at play here: the company reserved $15mm for losses due to store closures and co-tenancy effects on company NOI. In the meantime, it is filling in empty space with amusement attractions (e.g., Dave & Buster’s Entertainment Inc. ($PLAY), movie theaters, Dick’s Sporting Goods Inc ($DKS) locations, restaurants, office space and hotels. Sh*t…given the amount of specialty movie theaters allegedly going into all of these emptying malls, America is going to need all of those additional gyms to work off that popcorn (and diabetes). Get ready for those future First Day Declarations that delineate that, per capita, America is over-gym’d and over-theatered. It’s coming: it stretches credulity that the solution to every emptying mall is Equinox and AMC Entertainment Holdings Inc. ($AMC). But we digress.

All of these factors — the average rent decline, the empty square footage, etc. — are especially relevant considering the company’s capital structure and could, ultimately, challenge compliance with debt covenants. Net debt-to-EBITDA was 7.3x compared with 6.7x at year-end 2017. Here is the capital structure and the respective market prices (as of March 19):

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The new Senior secured term loan due ‘23:

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The Senior unsecured notes due ‘23:

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The notes due ‘24:

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The notes due ‘26:

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Additionally, the company is trying to promote how flexible it is with its ability to pay down debt and invest in redevelopment properties. Here is a snippet of the company presentation that displays the debt covenants on its revolver, term loan and other unsecured recourse debt:

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What is the real value of the mall assets that are left unencumbered? Recently, the Company has been slowly impairing a number of its assets and many of the Company’s tier 2 and 3 malls have yet to be revalued. If appraisers lower the value of these assets that are really supposed to be supporting the debt, what then?

And that doesn’t even take into consideration the co-tenancy clauses. As anchor tenants fall like flies, you’ll potentially see a rush to the exits as retailers with four-wall sales that don’t justify rents (and rising wages) exercise their rights.

So, given all of above, does the market share management’s (misplaced) optimism?

J.P. Morgan’s Michael W. Mueller wrote in a February 7, 2019 equity research report:

"While commentary in the earnings release noted some sequential improvement in 4Q results, we still see it being a grind for the company over the near to intermediate term."

BTIG’s James Sullivan added on February 20, 2019:

"We see no near-term solution for the owners of more marginal “B” assets like CBL & Associates. Sales productivity for such portfolios has shown little growth over the last eight quarters in contrast to the better-positioned “A” portfolios."

"The recent re-financing provides CBL with some near-term liquidity but limits future access to the mortgage market as only a small number of readily “bankable” assets remain unencumbered."

“We expect the challenging conditions in the industry to continue to create pressure on the operating metrics of mall portfolios with average sales productivity of less than $400/foot. More anchor closures are likely and in-line tenants are also likely to manage their brick-and-mortar exposure aggressively and close marginal locations. We reiterate our Sell rating and $2 price target.”

“With overall flat sales productivity in the portfolio, there is limited evidence that a turnaround in performance is likely in the next 24 months. Instead, we expect continued declines in SSNOI with negative leasing spreads and lower operating cost recovery rates.”

“CBL’s new facility which totals $1.185B is secured and replaces a series of unsecured term loans and a line of credit. Collateral includes 20 assets, of which three are Tier 1 Malls, 14 are Tier 2 Malls, and three are Associated Centers. As a result, CBL now has a much smaller number of unencumbered malls.”

“There are no unencumbered Tier 1 Malls (Sales exceeding $375/foot). There are nine unencumbered Tier 2 Malls (sales $300 -$375/foot) and those malls averaged $337/foot in 2017. The 2018 data is not available yet, but sales/foot for Tier 2 assets in 2018 declined by an average $5/foot. So assuming the law of averages applies, the average productivity of the unencumbered Tier 2 assets is $332/foot. Malls with that level of productivity cannot be financed in the CMBS market per CBL management.”

“With limited access to financing using their unencumbered malls, CBL has to look to its available capacity on its new line of credit, $265m, and projected free cash flow after paying its dividends, we estimate, of $155m in 2019 and $135m in 2020. CBL is currently estimating an annual capital requirement of $75m - $125m to redevelop closed anchor boxes. The per box range is $7m - $10m which we believe is low compared to peers whose cost per unit is closer to $17m. So CBL faces dwindling capital sources at the same time that its portfolio is suffering significant quarterly drops in SSNOI.”

Apropos, the shorts are getting aggressive on the name:

The historical stock chart is ugly AF:

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Which brings us to commercial mortgage-backed securities (CMBS) — derivative instruments comprised of loans on commercial properties. Canyon Partners’ Co-Chairman and co-CEO Joshua Friedman is shorting the sh*t out of mall-focused CMBS (containing among many other things, CBL properties) via a well known CDS index: the Markit CMBX.BBB- (and lower Indices) — to the tune of approximately $1b (out of $25b AUM). This is the mall-equivalent of the big short, except for commercial real estate. 🤔🤔

Here is a CMBX primer for anyone who wants to nerd out to the extreme. Choice bit:

CMBX allows investors to short CMBS credit risk across a wide array of vintages and credit ratings. Shorting individual cash bonds is difficult and rarely done, with the exception of a few very liquid names. The market for cusip level CMBS CDS used to exist, but the liquidity proved very poor and it was quickly replaced by trading of the synthetic indices.

And here is some color on what Mr. Friedman said regarding his trade:

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Wowzers. Just imagine what happens to retail — including the malls — when the noise gets even louder.

*Samuels Jewelers filed chapter 11 last year but announced liquidation this year after failing to secure a buyer for its assets.

We (STILL) Have a Feasibility Problem (Long the “Two-Year Rule”)

Payless ShoeSource Files for Chapter 11. Again.

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Man. That aged poorly AF.

That’s one + two + three…yup, three total “success” claims and that’s just the heading, subheading and intro paragraph. EEESH. This has turned into the bankruptcy equivalent of Oberyn Martell taking a victory lap in the fighting pits of King’s Landing.

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And, sadly, it almost gets as cringeworthy:

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Of course, we obviously know now that the Payless story is about as ugly as Oberyn’s fate.

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Payless is back in bankruptcy court — a mere 18 months after its initial filing — adorning the dreaded Scarlet 22. It will liquidate its North American operations, shutter over 2000 stores, and terminate nearly 20k employees. All that will remain will be its joint venture interests in Latin America and its franchise business — a telltale sign that (a) the brick-and-mortar operation is an utter sh*tshow and (b) the only hope remaining is clipping royalty and franchise fee coupons on the back of the company’s supposed “brand.” And so we come back to this:

That’s right. We have ourselves another TWO YEAR RULE VIOLATION!!

Okay. We admit it. This is all a little unfair. We definitely wrote last week’s piece entitled, “💥We (Still) Have a Feasibility Problem💥,” knowing full-well — thanks to the dogged reporting of Reuters and other outlets — that a Payless Holdings LLC chapter 22 loomed around the corner to drive home our point. Much like Gymboree and DiTech before it, this chapter 22 is the culmination of an abject failure of epic proportions: indeed, nearly everything Mr. Jones stated in the press release reflected above proved to be 100% wrong.

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Let’s start, given a dearth of new financial information, with the most obvious factor here as to why this company has round-tripped into bankruptcy — destroying tons of value and irreversibly hurting retail suppliers en masse along the way. In the company’s financial projections attached to its 2017 disclosure statement, the company projected fiscal year 2018 EBITDA of $119.1mm (PETITION NOTE: we’d be remiss if we didn’t highlight the enduring optimism of debtor management teams who consistently offer up, and get highly-paid investment bankers to go along with, ridiculous projections that ALWAYS hockey stick up-and-to-the-right. Frankly, you could strip out the names and, in a compare and contrast exercise, see virtually no directional difference between the projected revenues of Payless and the actual revenues of Lyft. Seriously. It’s like management teams think that they’re at the helm of a high growth startup rather than a dying legacy brick-and-mortar retailer with sh*tty shoes at not-even-discounted-for-sh*ttiness prices.

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On what realistic basis on this earth did they think that suddenly — POOF! — same store sales would be nearly 10%.

Seriously. Give us whatever they’re smoking out in Topeka Kansas: sh*t must be lit. Literally.

So what did EBITDA actually come in at? Depending on which paragraph you read in the company’s First Day Declaration filed in support of the chapter 22 petition: negative $63mm or negative $66mm (it differs on different pages). For the mathematically challenged, that’s an ~$182mm delta. 🙈💩 “Outstanding leadership team,” huh? The numbers sure beg to differ.

This miss is SO large that it really begs the question: what the bloody hell transpired here? What is this dire performance attributable to? In its 2017 filing the company noted the following as major factors leading to its bankruptcy:

Since early 2015, the Debtors have experienced a top-line sales decline driven primarily by (a) a set of significant and detrimental non-recurring events, (b) foreign exchange rate volatility, and (c) challenging retail market conditions. These pressures led to the Debtors’ inability to both service their prepetition secured indebtedness and remain current with their trade obligations.

The company continued:

Specifically, a confluence of events in 2015 lowered Payless’ EBITDA by 34 percent—a level from which it has not fully recovered. In early 2015, the Debtors meaningfully over purchased inventory due to antiquated systems and processes (that have since undergone significant enhancement). Then, in February 2015, West Coast port strikes delayed the arrival of the Debtors’ products by several months, causing a major inventory flow disruption just before the important Easter selling period, leading to diminished sales. When delayed inventory arrived after that important selling period, the Debtors were saddled with a significant oversupply of spring seasonal inventory after the relevant seasonal peak, and were forced to sell merchandise at steep markdowns, which depressed margins and drained liquidity. Customers filled their closets with these deeply discounted products, which served to reduce demand; the reset of customer price expectations away from unsustainably high markdowns further depressed traffic in late 2015 and 2016. In total, millions of pairs of shoes were sold below cost in order to realign inventory and product mix. (emphasis added)

You’d think that, given these events, supply chain management would be at the top of the reorganized company’s list of things to fix. Curiously, in its latest First Day Declaration, the company says this about why it’s back in BK:

Upon emergence from the Prior Cases, the Debtors sought to capitalize on the deleveraging of their balance sheet with additional cost-reduction measures, including reviewing marketing expenses, downsizing their corporate office, reevaluating the budget for every department, and reducing their capital expenditures plan. Notwithstanding these measures, the Debtors have continued to experience a top-line sales decline driven primarily by inventory flow disruption during the 2017 holiday season, same store sales declines resulting in excess inventory, and challenging retail market conditions. (emphasis added).

Like, seriously? WTF. And it actually gets more ludicrous. In fact, the inventory story barely changed at all: the company might as well have cut and pasted from the Payless1 disclosure statement:

The Debtors also faced an oversupply of inventory in the fall of 2018 leading into the winter of 2019. As a result, the Debtors were forced to sell merchandise at steep markdowns, which depressed margins and drained liquidity. Customers filled their closets with these deeply discounted products, which served to reduce customer demand for new product. In total, millions of pairs of shoes were sold at below market prices in order to realign inventory and product mix. (emphasis added)

As if that wasn’t enough, the company also noted:

The delayed production caused a major inventory flow disruption during the 2017 Holiday season and a computer systems breakdown in the summer of 2018 significantly affected the back to school season, leading to diminished sales and same store sales declines.

Sheesh. Did the dog also eat the real strategy? Bloomberg writes:

The repeat bankruptcies are a sign the original restructuring may have been rushed through too quickly or didn’t do enough to solve the retailers’ industry-wide and company-specific problems.

And this quote, clearly, is dead on:

“One of the easiest ways to waste time and money in Chapter 11 is to use the process only to effect a change in ownership but not to take the time and protections afforded by the bankruptcy process to fix underlying operations,” Ted Gavin, a turnaround consultant and the president of the American Bankruptcy Institute, told Bloomberg Law. 

This begs the question: what did the original bankruptcy ACTUALLY accomplish? Apparently, it accomplished this pretty looking chart:

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And not a whole lot more.*

The company also failed to achieve another key strategic initiative upon which its post-bankruptcy business plan was based: investment in its stores and the deployment of omni-channel capabilities that, ironically, would make the company less dependent upon its massive brick-and-mortar footprint. Per the company:

…the Debtors’ liquidity constraints prevented the Debtors from investing in their store portfolio to open, relocate, or remodel targeted stores to keep up with competitors.

And:

Moreover, Payless was unable to fulfill its plan for omni-channel development and implementation, i.e., the integration of physical store presence with online digital presence to create a seamless, fully integrated shopping experience for customers. As of the Petition Date, the completion of this unified customer experience has been limited to approximately two hundred stores. Without a robust omni-channel offering, Payless has been unable to keep up with the shift in customer demand and preference for online shopping versus the traditional brick-and-mortar environment.

In other words “success” really means “still too much effing debt.” This would almost be funny if it didn’t tragically end with the termination of thousands of jobs of people who, clearly, mistakenly put their faith in a management team so entirely in over their heads. Literally nothing was executed according to plan. Nothing.

Seven months after emerging from bankruptcy the company was already in front of its lenders with its hand out seeking more liquidity. Which…it got. In March 2018, the company secured an additional $25mm commitment under the first-in-last-out portion of its asset-backed credit facility. What’s crazy about this is that, never mind the employees, the supplier community got totally duped again here. In the first case, the debtors extended their suppliers by ONE HUNDRED DAYS only for them, absent critical vendor status, to get nearly bupkis** as general unsecured claimants. Here, the debtors again extended their suppliers by as much as 80 days: the top list of creditors is littered with manufacturers based in Hong Kong and mainland China. Who needs Donald Trump when we have Payless declaring a trade war on China twice-over? (PETITION NOTE: we know this is easier said than done, but if you’re a supplier to a retailer in today’s retail environment, you need to get your sh*t together! Pick up a newspaper for goodness sake: how is it that the entire distressed community knows that a 22 is coming and yet you’re extending credit for 80-100 days? It’s honestly mind-boggling. The company cites over 50k total creditors (inclusive of employees) and $225mm of unsecured debt. That’s a lot of folks getting torched.)

Some other notes about this case:

Liquidators. Much like with Things Remembered and Charlotte Russe, they mysteriously have bandwidth again such that they no longer need to JV up as a foursome as they did in Gymboree. Instead, we’re back to the slightly-less-anti-competitive twosome of Great American Group LLC ($RILY) and Tiger Capital Group.

Kirkland & Ellis. There’s something strangely ironic here about the fact that the firm went from representing the company in the chapter 11 to representing its liquidators in the 22. Seriously. You can’t make this sh*t up.

Independent Directors. Here we go again. Remember: the Payless 11 led us to Nine West Holdings which led us to Sears Holding Corp. ($SHLD). We have documented that whole string of disasters here. In the first case, Golden Gate Capital and Blum Capital got away with two separate dividend recaps totaling millions of dollars in exchange for a piddling $20mm settlement. Moreover, to incrementally increase the pot for general unsecured creditors, senior lenders had to waive their deficiency claims that would have otherwise diluted the unsecured pool and made recoveries even more insubstantial. So, here we are again. Two new independent directors have been appointed to the board and they will investigate whether controlling shareholder Alden Capital Management pillaged this company in a similar way that it has reportedly and allegedly pillaged newspapers across the country.***

Fees. If you want to quantify the magnitude of this travesty, note that the first Payless chapter 11 earned the following professionals the following approximate amounts:

  • Kirkland & Ellis LLP = $4.995mm

  • Armstrong Teasdale LLP = $495k

  • Guggenheim Securities LLC = $6.825mm

  • Alvarez & Marsal = $1.9mm

  • Munger Tolles = $898k

  • Pachulski Stang Ziehl & Jones LLP (as lead counsel to the UCC) = $2.5mm

  • Province Inc. = $2.6mm

  • Michel-Shaked Group = $560mm

Now THAT was money well spent.****


*Via three separate store closing motions, the company shuttered 686 stores. The second store closing motion proposed 408 store closures but was later revised downward to only 216.

**Unsecured creditors received their pro rata share of two recovery pools in the aggregate amount of $32.3mm, $20mm of which came from the company’s private equity sponsors as settlement of claims stemming from two pre-petition dividend recapitalization transactions. In exchange, the private equity firms received releases from potential liability (without having to admit any wrongdoing).

***Alden Global Capital is no stranger to controversy over its media holdings. In the same week it finds itself in bankruptcy court for Payless, Alden found itself in the news for its reported desire to buy Gannett. This has drawn the attention of New York Senator Chuck Schumer who expressed concerns over Alden’s “strategy of acquiring newspapers, cutting staff, and then selling off the real estate assets of newsrooms and printing presses at a profit.” 

***This is but a snapshot. There were several other professionals in the mix including, significantly, the real estate advisors who also made millions of dollars.

💰All Hail Private Equity💰

Private Equity Rules the Roost (Long Following the Money)

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

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

The American Lawyer recently wrote:

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

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

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

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

The American Lawyer continues:

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

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

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

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

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

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

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

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

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

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

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

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

*****

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

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

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

*****

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

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

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

The industry would stand to benefit if they did.

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

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

Screen Shot 2018-10-14 at 12.05.17 PM.png

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

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

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

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

*****

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

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

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

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

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

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

Oil & Gas is Back Baby

Long the West Texas’ Permian Basin; Short Anadarko

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

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

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

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

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

Ah, yield baby yield.

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

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

Apropos, Bloomberg noted this week:

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

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

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

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

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

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

Bloomberg continues:

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

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

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

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

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

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

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

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

Like we said. Winners and losers.

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

Long Blackstone. Short Market Timing.

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

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

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

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

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

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

And so does Blackstone. So does Refinitiv.

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

On September 8, the International Financing Review wrote:

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

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

Furthermore,

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

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

The International Financing Review quoted some investors:

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

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

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

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

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

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

Tell us how you really feel.

Reuters channeled the ghosts of TXU:

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

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

The Wall Street Journal wrote:

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

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

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

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

Per Bloombergorders

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

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

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

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

Back to International Financing Review quoting a high yield investor:

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

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

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

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

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

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

In other words, market timing is their jam.

What to Make of the Credit Cycle Part 12 (Long Yield, Baby, Yield).

The Rise of Litigation Finance

Investors have to generate yield somewhere. Hence, as we’ve discussed ad nauseum, the rise of alternative investment avenues such as venture capital and litigation finance. Wait. Litigation finance? Yes. Think Peter Thiel, Hulk Hogan and Gawker. This is a booming space.

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💰Private Equity Own Yo Sh*t (Short Health. And Care)💰

Forget Toys R Us. Private Equity Now Owns Your Eyes and Teeth

It has been over a month since media reports that Bernie Sanders and certain other Congressman questioned KKR about its role in the demise of Toys R Us (and the loss of 30k jobs). At the time, in “💥KKR Effectively Tells Bernie Sanders to Pound Sand💥,” we argued that the uproar was pretty ridiculous — even if we do hope that, in the end, we are wrong and that there’s some resolution for all of those folks who relied upon promises of severance payments. Remember: KKR declared that it is back-channeling with interested parties to come to some sort of resolution that will assuage people’s hurt feelings (and pocketbooks). Since then: we’ve heard nothing but crickets.

This shouldn’t surprise anyone. What might, however, is the degree to which private equity money is in so many different places with such a large potential societal impact. It extends beyond just retail.

Last week Josh Brown of Ritholtz Wealth Management posted a blog post entitled, “If You’re a Seller, Sell Now. If you’re a Buyer, Wait.” Here are some choice bits (though we recommend you read the whole thing):

I’ve never seen a seller’s market quite like the one we’re in now for privately held companies. In almost any industry, especially if it’s white collar, professional services and has a recurring revenue stream. There are thirty buyers for every business and they’re paying record-breaking multiples. There are opportunities to sell and stay on to manage, or sell to cash out (and bro down). There are rollups rolling up all the things that can be rolled up.

In my own industry, private equity firms have come in to both make acquisitions as well as to back existing strategic acquirers. This isn’t brand new, but the pace is furious and the deal size is going up. I’m hearing and seeing similar things happening with medical practices and accounting firms and insurance agencies.

Anything that can be harvested for its cash flows and turned into a bond is getting bought. The competition for these “assets” is incredible, by all accounts I’ve heard. Money is no object.

Here’s why – low interest rates (yes they’re still low) for a decade now have pushed huge pools of capital further out onto the risk curve. They’ve also made companies that rely upon borrowing look way more profitable than they’d ordinarily be.

This can go on for awhile but not forever. And when the music stops, a lot of these rolled-up private equity creations will not end up being particularly sexy. Whether or not the pain will be greater for private vs public companies in the next recession remains to be seen.

The Institutional Investor outright calls a bubble in its recent piece, “Everything About Private Equity Reeks of Bubble. Party On!” They note:

The private equity capital-raising bonanza has at least one clear implication: inflated prices.

Buyout multiples last year climbed to a record 10.2 times earnings before interest, taxes, depreciation, and amortization, according to S&P Global Market Intelligence. This year they remained elevated at an average of 9.5 times ebitda through May, a level surpassing the 2007 peak of the precrisis buyout boom.

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

*****

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

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

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

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

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

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

These aren’t one-offs.

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

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

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

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

Your next hospital visit may be powered by private equity.

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

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

Here’s a choice quote for you:

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

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

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

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

Nevermind this aspect:

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

Your next dental exam powered by private equity.

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

Your next cataracts surgery powered by private equity.

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

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

The Rise of Net-Debt Short Activism (Short Low Default Rates)

Aurelius Goes After Windstream Holdings Inc. 

🤓Another nerd alert: this is about to get technical.🤓

With default rates low, asset prices high, and a system awash with heaps of green, investors are under pressure by LPs and looking for ways to generate returns. They’ll manufacture them if needs be. These forces help explain the recent Hovnanian drama, the recent McClatchey drama and, well, basically anything involving credit default swaps (“CDS”) nowadays. To point, the fine lawyers at Wachtell Lipton Rosen & Katz (“WLRZ”) write:

The market for corporate debt does not immediately lend itself to the same kind of “activism” found in equity markets.  Bondholders, unlike shareholders, do not elect a company’s board or vote on major transactions.  Rather, their relationship with their borrower is governed primarily by contract.  Investors typically buy corporate debt in the hope that, without any action on their part, the company will meet its obligations, including payment in full at maturity.

In recent years, however, we have seen the rise of a new type of debt investor that defies this traditional model.

Right. We sure have. Boredom sure is powerful inspiration. Anyway, WLRZ dubs these investors the “net-short debt activist” investor.

The net-short debt activist investor has a particular modus operandi. First, the investor sniffs around the credit markets trolling for transactions that arguably run afoul of debt document covenants (we pity whomever has this job). Once the investor identifies a potential covenant violation, it scoops up the debt (the “long” position”) while contemporaneously putting on a short position by way of CDS (which collects upon a default). The key, however, is that the latter is a larger position than the former, making the investor “net short.” Relying on its earlier diligence, the investor then publicly declares a covenant default and, if it holds a large enough position (25%+ of the issuance), can serve a formal default notice to boot. The public nature of all of this is critical: the investor knows that the default and/or notice will move markets. And that’s the point: after all, the investor is net short.

In the case of a formal notice, all of this also puts the target in an unenviable position. It now needs to go to court to obtain a ruling that no default has occurred. Absent that, the company is in a world of hurt. WLRK writes:

Unless and until that ruling is obtained, the company faces the risk not only that the activist will be able to accelerate the debt it holds, but also that other financial debt will be subject to cross defaults and that other counterparties of the company — such as other lenders, trade creditors, or potential strategic partners — may hesitate to conduct business with the company until the cloud is lifted.  

Savage. Coercive. Vicious. Long low default rate environments!

In the case of Little Rock Arkansas-based Windstream Holdings Inc. ($WIN), a provider of voice and data network communications services, all of this is especially relevant.

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💰Goldman Sachs Has its Cake and Eats it Too💰

Short GNC Holdings Inc. Long Care/of. 

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We’ve written extensively hereherehere and here about GNC Holdings Inc. ($GNC) and the challenges that the company faces. We won’t revisit all of that here other than to note that GNC was, upon information and belief, preparing for a bankruptcy filing prior to it amending and extending its term loan, entering into a new ABL, and obtaining $275mm of asset-backed FILO term loans. We quipped that this was the quintessential “kick-the-can-down-the-road” transaction. Goldman Sachs ($GS) advised the company on the entire capital structure fix. Suffice it to say, then, that Goldman Sachs is intimately familiar with the GNC business.

Which, naturally, makes the fact that Goldman Sachs Investment Partners (a division of Goldman Sachs Asset Management) served as the lead investor in vitamin startup Care/of’s Series B financing all the more interesting.

Now, of course, we know Goldman is a big shop. They’re probably talking to WeWorkabout how to design their spaces to balance the sheer volume of “Chinese walls” with the need for an aesthetic that appeals to the millennial mindset. And, surely, Goldman Sachs’ capital advisory arm is entirely different and separate from Goldman’s asset management and venture arm.

But still.

Earlier this week Care/of, a direct-to-consumer wellness brand that specializes in monthly subscriptions of personalized vitamins and supplements, announced the new round of $29mm. In addition to Goldman, investors included Goodwater Capital, Juxtapose, RRE Ventures and Tusk Ventures. Former President of GNC, Beth Kaplan, also invested and will be joining the Board. 🤔

Bloomberg notes:

Care/of, a startup selling vitamins and herbal supplements online, raised funds from investors including Goldman Sachs Group Inc.’s venture arm that value the company at $156 million, within striking distance of publicly traded retail chains that are among the industry’s leaders.

The startup’s $156 million valuation isn’t far from Vitamin Shoppe Inc., with 3,860 employees and a market capitalization of about $203.5 million, or GNC Holdings Inc., which has a market value of $254.2 million with 6,400 employees. Care/of has about 100 workers, Chief Executive Officer Craig Elbert said.

“Consumers are increasingly shifting spend online and so I think large retail footprints have the potential to be a liability,” Elbert said in an interview. “There’s a lot of growth ahead of us and lot of reasons why this should be an e-commerce business.”

This is so Goldman-y. Collect an advisory fee to extend the life of the dominant brick-and-mortar retailer with one hand while investing in a nimble direct-to-consumer upstart that will chip away on that very same retailer on the other hand. Even before the former requires capital markets advice from a Goldman-type in a few years — which, it undoubtedly will — it may be on the lookout for an M&A banker. Perhaps to sell itself. Perhaps to buy a start-up and build a moat against Amazon. How convenient that Goldman will have familiarity with both businesses. We’d say that maybe there’d be a conflict somewhere in there but, well…do those really even exist anymore??

⚡️Important Toys R Us Update⚡️

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

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

Source: Settlement Motion, 7/17/18

Source: Settlement Motion, 7/17/18

Ah, the sacrifices.

💥KKR Effectively Tells Bernie Sanders to Pound Sand💥

Toys R Us (Short Severance Payments)

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

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

But wait. This keeps getting better.

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

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

The letter’s content? Per the WSJ:

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

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

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

Imagine the response:

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

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

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

Furthermore:

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

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

In other words: “Pound sand, Sanders.”

Bubbles (Short Prognisticators…Nobody Effing Knows)

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

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

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

Four days later, Lehman was bankrupt.

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