💥A War is Brewing: Elizabeth Warren vs. Private Equity💥

Scrutiny of Private Equity Increases

Private equity firms are sucking value out of our companies, putting people out of work, and wiping out newspapers and digital news outlets like @Splinter_News. I have a plan to hold these firms accountable. https://t.co/UxpLzyozU2

— Elizabeth Warren (@ewarren) October 11, 2019

It’s hard to take policy positions seriously at this stage in the run-up to Election 2020 but that’s not stopping Elizabeth Warren. Following up on her dead-on-arrival venue reform proposal of last year, Ms. Warren released her “plan” for a “Stop Wall Street Looting Act” in July and it came back again this week in the context of collapsing private equity owned media companies.* Oh boy. EW is about to have the fury of private equity fat cats rain down upon her. That is, if they think it has even the slightest chance of ever becoming reality (it likely doesn’t but…maybe increasingly does?). 

Ms. Warren minces no words. She starts broadly:

“To raise wages, help small businesses, and spur economic growth, we need to shut down the Wall Street giveaways and rein in the financial industry so it stops sucking money out of the rest of the economy.”

She then narrows her aim:

“Private equity firms raise money from investors, kick in a little of their own, and then borrow tons more to buy other companies. Sometimes the companies do well. But far too often, the private equity firms are like vampires — bleeding the company dry and walking away enriched even as the company succumbs.”

And: 

“…the firms can use all sorts of tricks to get rich even if the companies they buy fail. Once they buy a company, they transfer the responsibility for repaying the debt they took on to the company that they just bought. Because they control the company, they can transfer money to themselves by charging high “management” and “consulting” fees, issuing generous dividends, and selling off assets like real estate for short-term gain. And the slash costs, fire workers, and gut long-term investments to free up more money to pay themselves.” 

“When companies buckle under the weight of these tactics, their workers, small business suppliers, bondholders, and the communities they serve are left holding the bag. But the managers can just walk away rich and move on to their next victim.” 

PETITION NOTE: See, e.g., Toys R Us, Payless Shoesource, Gymboree, rue21, Nine West, Shopko. Retail has been a particularly bloodied victim of PE gone awry but there are no limits. She continues:

“These firms are gobbling up more and more of the economy. They own companies that employ almost 6 million people. They own the nation’s second-largest nursing home operator, the largest single-family rental landlord, the second-largest grocery store chain, and one of the nation’s largest payday lenders. But some of the hardest-hit industries are retail and local news.” 

Insert the likes of Sun Capital Partners and Alden Global Management here. At this point in her diatribe, Warren unleashes some hellfire with a vicious summary of the Shopko bankruptcy case and current state of affairs of Denver Post. You have to read it.

And she doesn’t stop there: she then EW unleashes a fury of napalm all over the PE model. For example, she wants PE firms to guarantee the debt put on the balance sheet of acquisition targets. Yup, you read that right: GUARANTEE the debt.

Think about this: PE firm XYZ takes Jesse Pinkman Media private. It puts $200mm of equity behind $1b of secured debt split between a revolving credit facility and two term loans. XYZ then engages in the usual PE playbook: within two years the company issues two new tranches of unsecured notes, the proceeds of which are used to pay dividends to XYZ. The company sells real estate, the proceeds of which are used to pay dividends to XYZ, and then leases back the real estate to the company. The company RIFs 150 employees, the cost savings of which are used to pay dividends to XYZ. The company then struggles to generate revenue, has very little cost cutting flexibility, no non-core assets to sell, and ends up in default. Noteholders can then go after the company AND XYZ?!? And not just for fraudulent conveyances in bankruptcy which, as we all know, hasn’t exactly played out so well?!? POP US THE GREATEST TASTING POPCORN OF ALL TIME. SH*T WOULD GET JUICY. 

Warren also wants to hold PE firms responsible for pension obligations of the companies they buy. Ooof. That would eliminate PE backing of a lot of industrial companies. Given that Warren would also like to regulate banks more stringently, where would these businesses get financing to grow and expand their businesses? How, then, would they be able to make pension contributions? 

She also wants to eliminate management fees and limit PE firms’ ability to pay themselves dividends (which would presumably include eliminating dividend recaps). This, in effect, completely redefines equity risk. 

She also wants to modify the bankruptcy rules so that workers get paid and management teams can’t pocket special bonuses. She’s basically saying that the Bankruptcy Code is doing a poor job of guarding workers rights and enforcing restrictions on incentive plans. Remember Toys R Us? Those clowns paid themselves bonuses on the eve of bankruptcy and then had the audacity to pursue another round of bonuses immediately after filing. Bold a$$ mofos. 

She also wants to prevent lenders and investment managers from making “reckless loans” and then passing along the danger to outside investors without maintaining any of the risk. In other words, she’s got her eyes on the syndication market too.

She also wants to eliminate carried interest which lets money managers pay lower capital gains rates rates rather than ordinary income tax rates. We’re old enough to remember when President Trump also said he’d go after this. Somehow, nobody ever does. Will Warren buck the trend?

She concludes:

“These changes would shrink the sector and push the remaining private equity firms to make investments that help companies rather than stripping them down for parts.”

Said another way, these changes could decimate the PE market.** 💥

*****

A recent study of private equity by researchers at Harvard University, University of Chicago, University of Michigan, University of Maryland, and the U.S. Census Bureau may or may not help matters. The study demonstrates that private equity does, in fact, lead to increased employment in certain scenarios while resulting in decreased employment in others. In a nutshell, within two years of a transaction, employment:

• ⬇️13% in buyouts of listed companies;

• ⬇️16% in carveouts (i.e., deals for a part of a company);

• ⬆️13% in buyouts of private companies; and

• ⬆️10% in private-to-private sales from one PE shop to another.

These contrasting outcomes call into question sweeping proposals like Ms. Warren’s — and y’all know we’re not exactly apologists for private equity. Indeed, the authors write:

In his presidential address to the American Finance Association, Zingales (2015) makes the case that we “cannot argue deductively that all finance is good [or bad]. To separate the wheat from the chaff, we need to identify the rent-seeking components of finance, i.e., those activities that while profitable from an individual point of view are not so from a societal point of view.” Our study takes up that challenge for private equity buyouts, a major financial enterprise that critics see as dominated by rent-seeking activities with little in the way of societal benefits. We find that the real-side effects of buyouts on target firms and their workers vary greatly by deal type and market conditions. To continue the metaphor, separating wheat from chaff in private equity requires a fine-grained analysis.

This conclusion cast doubts on the efficacy of “one-size-fits-all” policy prescriptions for private equity. Our results also highlight how buyouts can lead to large productivity gains on the one hand and job and wage losses for incumbent workers on the other. This mix of consequences presents serious challenges for policy design, particularly in an era of slow productivity growth (which ultimately drives living standards) and concerns about economic inequality. (emphasis added)

🤔

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*The news that sparked Ms. Warren’s renewed fire was the announcement that Splinter, a digital media company, was shutting down. G/O Media, backed by private equity firm Great Hill Partners, purchased the the news site from Univision back in April after Univision acquired the property post-Gawker dismantling. Ironically, as Dan Primack points out, the transaction was financed with all equity, not debt, which calls into question whether Warren’s plan even applies.

**Ms. Warren has already started targeting PE-owned for-profit colleges and prison service companies.

💰Retail Roundup (Long $FB, Long $RILY, Short Retail)💰

In “Thanos Snaps, Retail Disappears“ and “Even Captain America Can’t Bring Back This Much Retail (Long Continued Closures)“ we listed out the stupendous volume of retail closures that have transpired already in 2019. As we’ve stated before, there are no signs of this trend abating. Indeed, since the second piece shipped on April 28, 2019, several more companies have announced closures.

For instance, Francesca’s announced the closure of 20 stores. Regis Corporation ($RGS), the owner of Supercuts, is shedding 330 locations and, like so many other corporates, offloading risk onto unsuspecting franchisees. While its stock performance is strong, Carter’s Inc. ($CRI) closed a net 10 stores amid negative 3.7% comps. Sally Beauty Holdings Inc. ($SBH) closeda net 69 stores in the last year, primarily under its Sally Beauty Supply outlet. Outside of the conventional retail space, CVS Health Corporation ($CVS) is closing 46 locations this quarter.

One beneficiary of all of this: the liquidators. We can put some numbers around this.

Back in March, B. Riley Financial Inc. ($RILY) reported fiscal 2018 earnings. On the earnings call, the company noted the following:

Last year was also a banner year for our Great American Group retail liquidation division. We successfully completed the liquidation of the inventory assets of Bon-Ton Stores. For a sense of scale Bon-Ton was one of the largest U.S. liquidations in retail history by inventory value.

We completed the liquidation of over 200 stores with associated inventory value at approximately $2.2 billion. In 2018, we also participated in the liquidation of Toys "R" Us which contributed to our strong results in the segment. Momentum in this business is carrying forward into 2019 as a liquidation of Bon-Ton real estate assets continues to be under way and with our recently announced participation in the liquidations of Gymboree and Payless Shoes.

The Payless store closing event, which began on February 17, is the largest liquidation by store count in retail history with sales being conducted at approximately 2,100 stores and associated inventory value at over $1 billion. In January, the firm announced participation in the liquidation of 798 Gymboree and Crazy 8 stores across the U.S. and Canada.

RILY reported Q4 revenues of $10.1mm, a meaningful uptick from the $4.2mm the company reported in Q4 ‘17. Income rose from $0.1mm to $2.3mm YOY. For the year, revenues were $55mm and income was $27mm, a solid 49% margin. As for guidance, the company foreshadowed:

…momentum has already carried over into 2019. We expect to realize significant contributions from the Bon-Ton liquidation results for the first half, in addition to the results from our current involvement in Gymboree and Payless liquidations. We expect to see high levels of market activity to continue through Q2 as distressed retailers continue to focus on retail – real estate consolidation and purging excess inventory.

Last week, RILY reported Q1 ‘19 earnings and Great American Group continued to crush it. The “auction and liquidation segment” generated $20.7mm in revenue — double what it did in Q4 and more than 25% better YOY. Income increased to $11.5mm, or approximately 5x the income reported in Q4. This adds up to a margin of 55%.

Think about those numbers for a second: while retail employees are getting steam-rolled, stores are closing everywhere, malls are undeniably shaken and CMBS investors are, by necessity, vigilantly monitoring credit with a watchful eye, here is Great American Group absolutely rolling in dough on account of these retail liquidations. Great revenue, great income. Stellar margins.

Now, as we’ve discussed previously, there is an anti-competitive element in all of this. Rather than face off against one another and compress those beautiful margins, the liquidators all continue to engage in club deals for these big retailers. If the revenue, income and margin is THAT good, doesn’t that mean that debtors — and by extension, creditors thereof — are leaking a significant amount of value?🤔

****

Meanwhile, the news out of Facebook Inc. ($FB) probably had the liquidators over at Great American Group licking their chops. This week, Instagram is rolling out the ability for influencers to tag specific products in their photos, enabling consumers to click a photo, see what’s for sale, and purchase that product without ever leaving the Instagram feed. For those of you with zero design sensibility, suffice it to say that this is a big deal. No more friction of going back and forth between Instagram and external check out pages. This is going to mint tons of cash by the Kardashian and other influencer-influenced faithful.

Taylor Lorenz at The Atlantic writes:

Millions of users rely on influencers to sift through products and make recommendations. But until now, figuring out, for instance, exactly what shade of lipstick an influencer is wearing has been hard. Apps such as LikeToKnowIt, which allows you to shop influencers’ posts by taking screenshots, have garnered millions of users by providing a stopgap solution. Brand-specific social-shopping platforms such as H&M’s Itsapark have also stepped into the market. Still, many would-be consumers spend hours commenting on influencers’ Instagram posts asking for more product information, or fruitlessly attempting to locate a product online.

Interestingly, the influencers “won’t receive a cut of the sales their posts generate.” They will, however, get access to advanced metrics that may (or may not, as the case may be) arm them with leverage in negotiations with ad buyers. More from Lorenz:

“As an influencer, I don’t care if I don’t get a cut [of the sales] at the moment,” Song continued. “If it makes my followers’ life easier and they don’t have to message me asking ‘Where do you get that product?,’ I’m okay with doing it for free for now.” Many influencers are also betting that the increased engagement and spike in followers they’ll likely get by incorporating shoppable posts will more than pay off in the short term.

Color us skeptical. Much like the media is grappling with having a more direct relationship with its readers and that notion is pushing more and more writers to newsletters/subscriptions and away from advertising, we can’t help but to wonder how long influencers will be okay peddling other people’s products without getting a cut. With products like Shopify Inc. ($SHOP) enabling basically anyone the ability to create a direct-to-consumer business, it doesn’t stretch the imagination to conclude that a number of influencers are going to start getting into their own private label wares, if they haven’t already. It’s not like Kylie Jenner was having trouble moving product before: this gives her a shot of steroids.

What does this mean for retail? For starters, they’re going to be paying Facebook an awful lot of money out of their advertising budgets in the short term. In the longer term, however, they may find newfound competition from the likes of various Gen Z influencers that Gen X may have never even heard of. If malls are having trouble drawing traffic now, just imagine how much harder it will be when its easier for teen age Molly to just click on Instagram, scroll to her favorite influencer, and click through to some makeup without even interrupting continued scrolling. Facebook is savage.

Reminder: Nothing in this email is intended to serve as financial or legal advice. Do your own research, you lazy rascals.

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💰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 Us, Nine 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.

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.

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?🤔

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:

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

*****

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

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

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

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

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

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

These aren’t one-offs.

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

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

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

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

Your next hospital visit may be powered by private equity.

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

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

Here’s a choice quote for you:

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

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

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

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

Nevermind this aspect:

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

Your next dental exam powered by private equity.

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

Your next cataracts surgery powered by private equity.

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

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

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

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⚡️Important Toys R Us Update⚡️

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

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

Source: Settlement Motion, 7/17/18

Ah, the sacrifices.

💩Will KKR Pay Toys' Severance? Part II. 💩

On Wednesday we bashed Dan Primack’s notion that KKR would fund Toys R Us’ severance payments. Apparently we weren’t the only ones. Primack subsequently wrote:

• Equity share: In writing about Toys "R" Us on Tuesday, I mentioned that private equity firms have an obligation to portfolio company employees. Some readers pushed back via email, but it's worth noting that Toys backer KKR has been providing equity to some of its portfolio companies (including Gardner Denver, CHI Overhead Doors and Capsugel).

• Obviously it's not apples-to-apples with Toys, but such equity-share does reflect a more modern private equity mentality toward portfolio company employees. Bloomberg wrote about the Gardner Denver example last year.

There’s ZERO CHANCE IN HELL KKR funds severance payments. Just stop Dan. If we’re wrong, we’ll gladly eat this.

💩Will KKR Pay Toys R Us' Severance?💩

Optimism Remains in Toys R Us Situation

Surprisingly.

You’d think that every person on the planet would be sufficiently jaded by anything Toys R Us at this point. Apparently not everyone. And, oddly, the optimism seems to come from someone typically critical/skeptical of private equity…

Yesterday Axios’ Dan Primack’s lead piece asked, “Should the former private equity owners of Toys "R" Us pay around $70 million in severance to the company's 33,000 laid-off employees?” The question seems to stem from reports that limited partners (i.e., pension funds) are questioning what took place with the Toys investment. We noted this on Sunday:

🔥Elsewhere in private equity, maybe there’ll be backlash emanating out of Toys R Us?? The Minnesota State Board of Investment voted to halt investments in KKR pending a review of the bigbox toy retailer. 🔥

With this as background, Primack wrote:

This is not an academic question. It's become the subject of some public pension investment committee meetings, prompted by a lobbying campaign by left-leaning nonprofit advocacy groups, and has gotten the private equity industry's attention.

• The basic argument: Bain Capital, KKR and Vornado killed Toys "R" Us by saddling it with too much debt, while taking out fees along the way. It's only fair that they help folks who are without work because of private equity's mismanagement, particularly when PE firms are so rich and many of the employees were living paycheck-to-paycheck.

• The legal argument: There is none. The private equity firms no longer own Toys "R" Us, and a bankruptcy court judge threw out the severance package because employees weren't high enough in the creditor stack.

We’re old enough to remember when mass shootings got private equity’s attention too. They promised to divest. They didn’t. And then Vegas happened. And then Florida happened. And then Bank of America ($BAC) swore off lending to gun companies only to, uh, lend to Remington Outdoor Company.

We’re old enough to remember people like Warren Buffett say that they should pay more in taxes. That his secretary has a higher effective tax rate than he does. But, to our knowledge, he didn’t exactly voluntarily write a billion dollar check to the U.S. Treasury.

Likewise, neither will KKR write a severance check to employees. No frikken way in hell. Why? Because there is no compulsion to do so. The legal argument? He’s right, “[t]here is none.” So, yeah, good luck with that.

And so the above is really where the piece should stop. A nice little moral high ground piece about how employees and vendors got effed, it is what is, now on to tariffs, Petsmart’s asset stripping “mystery,” Harley Davidson’s ($HOG) war with President Trump or Moviepass owner Helios & Matheson’s ($HMNY) stock hitting a record low.

But Primack also points out,

Finally, the pro-severance folks are a bit liberal (no pun intended) with their math. They argue the PE firms took out $464 million, by adding up advisory fees ($185m), expenses ($8m), transaction fees ($128m) and interest on debt held by the sponsors ($143m). Yes, we were first to point out how the general partners may have gotten back more than they put in. But some of those fees were shared with LPs — including the now-aghast public pensions — while the interest was held in CLOs that had their own investors. In other words, PE "profit" was much smaller than claimed (although, on the flip side, you could argue the firms collected management fees on Toys-related capital that ended up being set on fire... again, it's complicated). (emphasis added)

Right. We’re sure the Minnesota State Board of Investment is cutting a check as we speak.

Sadly Primack didn’t stop there; he continued,

PE firms do have moral obligations to portfolio company employees. You break it, you own it (even if you technically broke it while owning it, which caused someone else to own it).

Um, ok, sure.

He continues,

Bottom line: The PE firms should pay at least some of the severance, or figure out some other form of compensation. And I have a sense that they might. Not because of preening public pension staffers or legal obligations, but because it's the right thing to do. Sometimes it's just that simple.

LOL. Riiiiiiight. In the absence of Mr. Primack having an inside track at KKR, it’s just that fantastic (def = “imaginative or fanciful; remote from reality.”).

Asset Values Soar: Human Asset Values. (Long Inflation)

Asset values have been soaring off into the stratosphere to the point that even Warren Buffett is complaining about a dearth of reasonably-priced opportunities (hence his short dalliance with Uber?). The FED, meanwhile, is keeping tabs on inflation; perhaps the Fed ought to look no farther than the legal world. It is experiencing two forms of inflation this week.

First, Milbank Tweed Hadley & McCloy announced that it was raising first year associate salaries to $190k and generally all associate salaries between $10k-15k. Choice bit from The American Lawyer:

“Two years have now gone by, and there is cost-of-living increases and inflation,” Edelman said. “We want to signal to the market that we do want the best, and we’re willing to pay for the best, and we think after two years, an additional increase is appropriate.”

Inflation indeed. As one biglaw partner told us a year ago, a clear cut sign of a market top is when biglaw firms raise first year associate salaries. Well, then…let the recession commence!

Indeed, nothing says "good timing" (or income inequality) like a pay raise to know-nothing lawyers at a time when Toys R Us’ fees are front page news and mad-as-hell employees are picketing KKR's offices. Sometimes biglaw can be its own worst enemy. More:

Edelman said the change would not have “a material effect on firm finances,” adding that he didn’t expect partner capital contributions to change.

Right. Because with 500 associates, the extra $5 million in expense will surely be passed on to the clients. Get ready for a fee increase folks. That’s something worth singing about in court even.

Anyway, we’re not hating. After all, Milbank needs to incentivize people to go to law school AND choose them over several other biglaw firms. Why would anyone do that if they can make $40k/month as a social media influencer? Why would anyone do that if they can be “Running a $500,000 Retail Empire by iPhone?” Good and serious question. That is the competition these days.

*****

Second, Weil Gotshal & Manges LLP announced that, in an effort to incentivize lawyers to stay, partnership (and, for some, counsel position) will now be offered to lawyers that have been with the firm for a mere 7.5 years. Per the ABA Journal,

Weil, Gotshal & Manges hopes to improve associate retention by cutting the wait for partnership by two years. 

Except, those "partners" will be non-share partners making “fixed income” rather than receiving partner distributions. And, except, further,

Lawyers in the niche counsel category for specialty practices can remain there as long as they stay at the firm. Lawyers in the other category get, at most, three years in the position. During that time, they may be promoted to partner. Those who don’t make it will be transitioned out of the firm.

Hahaha. C’mon. So you’ll basically have 10.5 years to prove that you merit equity partner before they unceremoniously toss you out into the wilderness…uh, sorry…”transitioned.” You know, rather than 9.5 years. But that new title though!! Title inflation!!

Query: where did Weil get that idea from? (Cough, Kirkland & Ellis). What's that saying: imitation is the sincerest form of flattery? We guess they’re waiting 7.5 years before labeling someone a “partner” rather than 6 years so, uh, there’s that. Just what biglaw needs: more lawyers running around with an inflated sense of self.

On point.

DO. NOT. MESS. WITH. DAISY. CHAPTER 1 of 3 (Short Pet Suppliers) 🔫

🐶 Phillips Pet Food & Supplies: "Outlook Negative" 🐶

We have covered a lot of ground since our inception and, for the most part, the path has been trodden with depressing stories of disruption and destruction. The root causes of that run the gamut - from (i) Amazon ($AMZN) and other new-age retail possibilities (e.g., resale and DTC DNVBs) to (ii) busted PE deals to (iii) fraud and mismanagement. Through it all, nothing has really gotten us too fired up — not the hypocrisy surrounding Bank of America’s ($BAC) loan to Remington Outdoor or the hubris around Toys R Us. But, once you start effing with our dogs’ diets, that’s when we have to start getting all-John-Wick up in this mofo. 

Enter PFS Holding Corp., otherwise known as Phillips Pet Food & Supplies (“PFS”). PFS is a distributor of pet foods, grooming products and other useless over-priced pet gear. It is private equity-owned (sponsor: Thomas H. Lee Partners) and has $450+ million of LBO-vintage debt spread out across a recently-refinanced $90 million revolving credit facility (pushed to 2024 from January 2019), a cov-lite ‘21 $280 million term loan, and a cov-lite ‘22 $110 million second lien term loan.

The company recently got some breathing room with a freshly refi’d revolver but still has some issues. While quarterly sales increased in Q4 from $293 million to $327 million, gross margins were down — a reflection of price compression. EBITDA was roughly $62 million on a consolidated adjusted basis clocking the company in at right around a 7.4x leverage ratio. The ‘21 and ‘22 term loans both trade at distressed levels, reflecting the market’s view of the company’s ability to pay the loan in full at maturity. Upon information and belief, the new revolver includes a 90-day springing maturity which means that the company is effed if it is unable to refi out the term loan prior to its maturity (which, admittedly, seems lightyears away from now).

All in, S&P Global Ratings appears to think that the Force is weak with this one; it issued a corporate downgrade and a term loan downgrade of the company on April 10, 2018. Why? Well, S&P doesn’t pull any punches:

“The downgrade reflects our view that, absent significantly favorable changes in the company’s circumstances, the company will seek a debt restructuring in the next six to 12 months, particularly given very low trading levels on its second-lien debt, between 30 and 40 cents on the dollar. It also reflects our view that cash flow will not be sufficient to support debt service and maintain sufficient cash interest coverage, resulting in an unsustainable capital structure. We forecast adjusted leverage in the mid-teens. PFS recently lost a substantial portion of business with one of its largest customers, which we believe represented over half of the company’s EBITDA. Management implemented several cost savings initiatives last year, but we do not believe savings achieved will be sufficient to offset this dramatic profit loss. Further, we expect the company will continue to be pressured by a secular decline in the independent pet retail market, which we view as PFS’ core customer base. Independent pet shops continue to lose market share to e-commerce and national pet retailers, as consumer adoption of e-commerce for pet products purchases grows.”

There’s a lot there. But, first, who writes these dry-as-all-hell reports? If any of you has a connection at S&P, consider putting us in touch. We could really spice these reports up.

Here’s our take:

“The downgrade reflects the fact that this business is turning into garbage. The company was hyper-correlated to one buyer, is over-levered and is, in real-time, succumbing to the cascading pressures of e-commerce and Amazon. In the age of the internet, nobody needs a distribution middleman. Particularly at scale. The lost customer reflects that. Godspeed, PFS.”

Just saved like 1,382,222 words.

S&P further predicts a double-digit sales decline and negative free cash flow in 2018 and 2019, “with debt service and operating expenses funded largely with asset-backed loan (ABL) borrowings.” Slap a mid 5s multiple on this sucker and it looks like the first lien term loan holders will eventually be the owners of a shiny not-so-new pet food distributor! Dogs everywhere lament.

The Fallacy of "There Must be One" Theory

Dick's Sporting Goods, Toys R Us, iHeartMedia, & Amazon

Ah, R.I.P. Toys R Us.

This week has undoubtedly been painful for employees, vendors, suppliers and fans of Toys R Us. The liquidation of the big box toy retailer is a failure of epic proportions; many creditors will be fighting over the carcass for months to come — both inside and outside of the United States; many employees now have two months to find a new gig; many suppliers need to figure out if and how they’ll be able to manage now that they’re exposure to unpaid receivables has increased. Good thing the company’s CEO is a man-of-the-people who can help cushion the blow.

Hardly. Enter CEO David Brandon and his shameless, out-of-touch attempts to cast blame onto outside parties: “The constituencies who have been beating us up for months will all live to regret what’s happening here.” Wait. Huh?!

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😡Private Equity Faces Increasing Headwinds 😡

Warby Parker, Claire's Stores, Toys R Us & More

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Retail Roundup (Some Surprising Results; More Closures)

Retail Remains in a State of Transition

• Macy’s ($M) reported earnings earlier this week and surprised to the upside - particularly with the news that its sales grew in the latest quarter (after 2.75 years of consistent decline). Most of the upside came from cost control measures (and the expansion of its off-price offering, Backstage). Likewise, Dillard’s.

• Toys R Us entered administration in the UK.

• Charlotte Russe earned itself what we would deem a “tentative” upgrade after consummating an out-of-court exchange transaction that delevered its balance sheet. S&P Global cautioned that it expects “liquidity to be tight” over the next 12 months.

• Chico’s FAS Inc. ($CHS) reported same store comp sales down 5.2% and indicated that it closed 41 net stores in 2017, including 14 net stores in Q4. Net income and EPS was higher.

• Foot Locker ($FL) intends to close net 70 stores in 2018 after closing net 53 stores in 2017.

• Kohl’s Corp. ($KSS) is becoming a de facto co-retailing location after first partnering with Amazon ($AMZN) and now Aldi.

• JCPenney ($JCP) announced that it is cutting full-time employees and increasing use of part-time employees instead. Total sales rose 1.8% but missed estimates. Comparable sales rose 2.6% and net income, ex-tax reform benefits, was down 6.6%.

• Office Depot ($ODP) reported comp store sales declines of 4% and total sales down 7%. It closed 63 stores, including 26 in Q4. Note that we’re not reporting net closures: the company didn’t open any stores.

• Supervalu may be shutting down 50 Farm Fresh Supermarkets in North Carolina and Virginia.

Toys R Us is a Dumpster Fire

All Signs Point to the Big Box Retailer Being in Serious Trouble

This week AlixPartners LLC released its latest "Retail Viewpoint" and its "Monthly Retail and Economic Update." Both documents cover retail results from the ever-important holiday season. Alix says this in its preface:

"The year 2017 may have been one of apocalyptic headlines, but a lot of forecasts—including ours—still predicted that retailers would have a good holiday performance.

No one thought it would be this good.

According to advance and preliminary numbers from the US Census Bureau, retailers brought the noise this past holiday-shopping season. Core retail sales increased 6.3% over 2016's, blowing past the National Retail Federation's forecast—and ours too. Sales in November and December were absolutely explosive, accounting for 17.2% of annual sales, the largest percentage since 1999.

Every core retail sector performed significantly better than it did the rest of the year (figure 1). Not even public enemy number one—e-commerce pure plays—could stop other sectors from increasing 2.3% during the holiday season compared with the rest of 2017. There must have been a lot of happy little kids (and bigger kids) gathered 'round the tree, because the poster children of recession-era bankruptcies, electronics and sporting goods/hobby/book/music stores, had the largest increases of all: 7.4% and 4.7%, respectively."

While there may have been "a lot of happy little kids," we're guessing they were NOT "Toys R Us kids." 

Consider this week's Toys R US-related operational news: 

• The Washington Post reports that 182 stores will close, with CEO Dave Brandon acknowledging "operational missteps" during the holiday season. The article cites various issues including (i) confusion around the bankruptcy filing, (ii) fear of buying gifts that can't be returned, (iii) weak marketing, and (iv) ineffective email promotions. An analyst at BMO Capital Markets notes that holiday sales in North America were down more than 10%. On the bright side, Reuters reports that all 83 stores in Canada will remain open.
• Quartz notes that the company seeks permission to pay store closing bonuses to those employees who help the company wind down the aforementioned 182 stores (which, for the record, is roughly 20% of the US footprint). Notably, neither the company nor Quartz is estimating the sheer number of jobs these closings affect. But it will be a meaningful number. #MAGA!!
• Bloomberg reported that the company obtained court approval to pay landlords' fees and expenses related to the Chapter 11 case in exchange for additional time for the company to decide whether to assume or reject leases. Nerd alert: the bankruptcy code imposes a 210-day deadline for a company to decide a course of action vis-a-vis its non-residential real property leases. These promised payments were in exchange for an extension of that timeframe. 

And consider, further, this week's Toys R Us-related financial news:

• Per RetailDive, Toys R Us won't release holiday sales results. 
• Per Debtwire, Toys R Us circulated a limited holiday performance snapshot for its international enterprise. The report didn't include number after December 23. Yes, Christmas is on December 25. 

We wonder: why the reluctance to release numbers? Our suspected answer: they must be ugly AF. In the period of October 29 - November 25, the company reported a net deficit (disbursements > receipts) of approximately $53mm. Later this week, we should see the company's monthly filing for the period covering Christmas. We don't like to speculate, but we can only imagine that the deficit will be even greater; we suspect that the company is burning cash like nobody's business. And we're wondering whether a liquidation of the US side of the business is out of the question given all of the "missed opportunities." 

For now, what we KNOW is that - through no fault of its own - Alix' assessment is incomplete. The fine folks over there may want to amend their report after we hear more from Toys R Us in coming days. 

**********

By extension of the above - and now is as good a time as any to remind you that nothing we write should be construed as investment advice - we'd think it's also safe to assume that this Bloomberg piece about efforts by Hasbro Inc. ($HAS) and Mattel Inc. ($MAT) to innovate is, maybe, a wee bit too rosy. While, yes, they may be pivoting towards mobile and less dependence on brick-and-mortar, how many times have we heard that a transition is slower and harder than anticipated? That excuse is cited in virtually every retail "First Day Declaration" of the past two years. We don't have high hopes for Q4 reports (Mattel supposedly reports Q4 earnings on 2/1 followed by Hasbro on 2/7). Along those lines, Meisheng Cultural Co. may want to wait and see what happens to Jakks Pacific's ($JAKK) numbers before it overpays. 

One last related note: Sphero, the Disney-backed ($DIS) maker of STEM toys like a robotic BB-8 that you can buy at...wait for it...TOYS R US, announced earlier this week that it was laying off 45 staff members globally "following a holiday season that failed to live up to expectations." Curious. Maybe it was too dependent upon a certain big box toy retailer? 

Elizabeth Warren vs. the Bankruptcy Bar

A Reminder That Disruption Takes on Many Forms

PETITION is, broadly speaking, a newsletter about disruption. As loyal readers have surely noticed, the predominant emphasis, to date, has been tech-based disruption. But, spoiler alert, there are other forms. Earlier this week, Senators Elizabeth Warren and John Cornyn proposed a bill that swiftly reminded a cohort of (mostly Delaware) legal professionals that legislation, if passed, can be an even more immediate, powerful and jarring form of disruption.

Let’s take a step back. Shortly before Christmas, the Commercial Law League of America (CLLA) indicated that the U.S. Senate should consider a new bankruptcy venue reform bill. The gist of the proposal is that a debtor should have to file for bankruptcy in its principal place of business (or where their principal executive offices reside) - as opposed to, as things currently stand, its state of incorporation (the "Inc Rule"), where an affiliate is located (the "Affiliate Rule"), or where a significant asset is located (the "Abracadabra Rule"). Notably, a large percentage of companies are incorporated in Delaware, a state with well-established and well-developed corporate laws and legal precedent. Consequently, thanks to the "Inc Rule," Delaware is typically the most sought after venue by debtors, perennially topping annual lists with the most bankruptcy filings. In other words, the state of Delaware is the biggest beneficiary of the status quo. 

Putting aside the Inc Rule for a moment, the “Affiliate Rule” and “Abracadabra Rule,” respectively, have provided debtor companies with wide and crafty latitude to file in jurisdictions other than that of their principal place of business. Again, typically Delaware (and then, to a lesser extent, New York). Have a non-operating subsidiary formed in Delaware? Venue, check on the "Affiliate Rule." Got a random (unoccupied) office you set up last week in a WeWork in Manhattan? POOF, venue! Check on the "Abracadabra Rule." Got a bank account set up (a week ago) with JPMorgan Chase Bank in New York? Venue, again check on the "Abracadabra Rule". It is, seemingly, THAT optional. All of this is like saying that despite the entire automobile industry being manufactured, headquartered and principally-based in Detroit, General Motors ($GM) should file for bankruptcy in New York rather than Michigan. Oh, wait. That actually happened. Take two: that’s like saying that despite the entire automobile industry being manufactured, headquartered and principally-based in Detroit, Chrysler should file for bankruptcy in New York rather than Michigan. Damn. That also happened. Ok, here’s a good one: that’d be like saying it’s okay for the Los Angeles Dodgers to file for bankruptcy in Delaware rather than California. Wait, SERIOUSLY!?!? WTF. Who is to blame for this outrage? 

We'll keep this simple, lest this become a treatise absolutely nobody will want to read: federalism. Bankruptcy law is federal but every state has their own courts, circuit courts, and legal precedent. Some states have bankruptcy courts that are historically more favorable to debtors (cough, Delaware...need that incorporation business) - which, speaking commercially and realistically - are de facto clients of the state. Currently, debtors typically choose the venue so if you want to drive debtors to your courthouse steps, favorable corporate and debtor-favorable bankruptcy case precedent goes a long way towards filling court calendars. Not to mention hotels. In this regard, the bankruptcy court isn't all too dissimilar from a large tech company. Go fast and furious to market, aggregate a ton of users (here: debtors), acquire talent (read: judges), and build a database full of information (read: precedent) to then use against everyone else who tries to compete with you. That aggregation is the moat, the competitive advantage. Say, "we're the most sophisticated due to our talent, data, and predictability" and win. Boom. Dial up the Hotel Du Pont please!  

As a consequence of federalism, one jurisdiction's "makewhole provision" enriching bondholders is another jurisdiction's "no recovery for you" enraging bondholders. One jurisdiction's "restructuring support agreement" is another jurisdiction's "meaningless bound-to-be-blownup-worthless-piece-of-paper." That's the beauty of venue selection, currently. The system allows debtors to choose based on that precedent. Ask any of your biglaw buddies about "venue analysis" and watch their eyes roll into the back of their heads. That is, if you're even still reading this. They've all had to do it. It's a big part of the filing calculus. And everyone knows it. 

Enter Senators Warren and Cornyn. They're saying, "No way, Jose. This sh*t needs to stop." Okay, they didn't say that, exactly, but Senator Warren did say this, "Workers, creditors, and consumers lose when corporations manipulate the system to file for bankruptcy wherever they please. I’m glad to work with Senator Cornyn to prevent big companies from cherry-picking courts that they think will rule in their favor and to crack down on this corporate abuse of our nation’s bankruptcy laws.” The argument goes that the bill “'will strengthen the integrity of the bankruptcy system and build public confidence' by availing companies, small businesses, retirees, creditors and consumers of their home court." Ruh roh. 

A few years ago, a heavy hitter lineup of restructuring professionals were asked by The Wall Street Journal what they thought about this venue debate. The general upshot was "nothing to see here." With apologies for the paywall attached to the following links, you'll get the general idea. See, e.g., "the myth of forum shopping." See, also, "venue reform is a solution in search of a problem."; 
“allowing fiduciaries to exercise their business judgment about what filing location might maximize enterprise value or reduce execution risk or both.”; “If it ain’t broke, don’t fix it.”; "the current status quo of wide venue choice – should win out.”; “It’s not clear that these rules are problematic, so don’t apply a fix with its own set of unintended consequences.”; “The truth is that venue provisions are very appropriate and do not need to be adjusted”; "Letting debtors choose as they can now is 'good business sense.'"; and "current venue requirements 'strike a fair balance.'” In summary, you've got Senators Warren and Cornyn up against a LARGE subset of the bankruptcy bar. And those aren't all Delaware practitioners. That's a cross-section of the entire bar - with some financial advisors and investment bankers thrown in for good measure. Pop us some popcorn.

Now, we've been highlighting venue shenanigans since our inception. Not because it's wrong to leverage a favorable venue with uber-favorable precedent if you have that option; rather, because it has gotten so FRIKKEN OBVIOUS. Clearly an industry with $1750/hour billing rates isn't known for its subtlety. Want a third-party release to shield the private equity bros? St. Louis here we come! Have the opportunity to take advantage of a "rocket docket" and get those billable rates rubber stamped? Godspeed. Want to issue a "Standing Order" to divert bankruptcy traffic (back) into your court? May the Force be with you. 

That last bit is particularly notable. Venue gaming got so blatant that even the courts got in to the game. That "Standing Order" is as patent an acknowledgement of venue manipulation as anything we've seen of late. Why did this happen? Take a look at the case trends. After a few early (small) oil and gas exploration and production companies (E&P) filed in Texas and things, uh, didn't go particularly well for professionals, a deluge of E&P debtors mysteriously started popping up in Delaware. That's basic cause and effect. The subsequent cascading secondary effect was the "Standing Order" which, in response, guaranteed professionals that they'd get one of two judges and that, effectively, the Texas courts were open for business. Once that Order came out, debtor traffic curiously reverted back to Texas. E&P management teams and creditors could be heard in their home jurisdiction. Local firms could become "local counsel." Delaware counsel's loss was Texas counsels' gain. (If only the same could be said for lead counsel). Naturally, then, both the Texas Bankruptcy Bar Association and Texas Hotel & Lodging Association back the proposed bill: it basically fortifies the Standing Order. Also, guess where Senator Cornyn is from? Alexa, please cancel that Hotel Dupont reservation. 

We're not taking a position in this debate. We have no skin in that game. But we can't help but to chuckle at the timing. Ironically, it seems that more and more debtors are filing near their principal place of business rather than Delaware anyway (cough, third party releases!). See, e.g., Toys R Us, rue21, Payless Shoesource. And so this has the potential to reinforce a recent trend and compound the issues that have already surfaced for Delaware professionals. 

This is nerdy sh*t. But it’s still big deal disruption. Just disproportionately for the Delaware bar and the city of Wilmington. It’s so big that even iHeartRadio released a podcast discussing it. Without irony. Dramatic disruption AND comedy. 

Who knew bankruptcy could be so entertaining?

A Brutal Week for Toys R Us (Short Giraffes)

The week isn't even over yet and so far it's been full of good news and bad news for Toys R Us. Who are we kidding? It was mostly bad. The good news first: the bankruptcy court granted the company additional time to (i) exclusively submit a plan of reorganization and (ii) figure out what it wants to do with its store leases. So, rather than reject its leases by mid-January, the company now has until mid-April. The benefit of this, of course, is that the company gets to take advantage of its store footprint during the crucial holiday season. The disadvantage of this, however, is that it eliminates an excuse for dogsh*t numbers in Q4 '17.

Speaking of dogsh*t numbers, the company reported Q3 '17 results. The newly enriched company CEO Dave Brandon didn't use "dogsh*t" to describe the results but he might as well have, saying "[o]ur results for the quarter were disappointing." Right after that he threw babies and smart kids (read: "learning") under the bus, highlighting those segments as particularly challenging. Here are the highlights:

• Same store sales were down 4.4%. 
• Net sales were down $89mm. 
• Gross margin was down 4% (and 5.8% in the US due to vendor tightening and a "competitive pricing strategy," otherwise known as discounting).
• SG&A was up $13mm (subsuming restructuring advisory fees...these guys have no idea what's coming on that front).
• Operating loss was $208mm.
• EBITDA was negative $97mm, a $102mm swing from the prior year period. 
• Net loss of $624mm compared to $160mm in the prior year period. 

In other words, B.R.U.T.A.L. 

Hang on though. Things can't be all bad can they? Well, in the UK there are fears of a full shutdown (firewall) and thousands of job losses. But what about Star Wars driving massive toy sales? Apparently that isn't looking like quite A New Hope either. See what we did there?

Toys R Us Plan to Pay Execs Makes Waves

Toys R Us' Execs Seek Hefty Bonuses, Piss People Off

Happy holidays, ya'll. You're fired. In what should be a surprise to no one, Toys R Us isn't immune to store closures. In the first instance, it plans to close 25 UK-based locations. If you think the US won't see closures and/or consolidation of Toys/Babies shops, you're smoking some serious crack (as we've said before). Indeed, the company recently filed a motion establishing procedures to extend the time to deal with its non-residential real property leases. Buckle your seat belts, landlords. 

Speaking of smoking crack, the U.S. Trustee for the Department of Justice (UST) apparently thinks the company and its advisors have been at it with the good stuff; it went full-on Demi Moore with its vigorous objection to the company's mid-November motion to pay executives up to $32mm in bonuses if "Stretch" EBITDA targets are met (and slightly less upon achievement of a "Target" EBITDA level). These numbers - on the heels of millions of dollars of pre-bankruptcy bonuses paid to the very same executives - made their way through the mainstream (and not so mainstream) media and garnered some well-deserved outrage. PETITION NOTE: All of the sudden everyone is an executive compensation expert, it seems. To be fair, it is awfully counter-intuitive that the very same professionals at the helm when the ship hit Iceberg #1 need incentives to avoid Iceberg #2. Like, "eff you, guys, good luck getting a job elsewhere after this dumpster fire of a hot mess" seems to be the general public sentiment. But therein lies the push-pull bankruptcy dynamic. Switch out management now - while credit terms are non-existent, vendor/supplier relationships are strained, customers are nonplussed, competitors are champing at the bit, etc. - and its possible that, with the absence of institutional knowledge, the company could end up in even WORSE shape and stumble towards liquidation. And so this is where the Kirkland & Ellis LLP attorneys - all SEVEN of the partners listed on their filed papers - really earn their billing rate (a point we're guessing they hammer home whilst pitching management teams); they need to convince the Judge, the UST and, here, the public, that the lofty amounts they seek approval for derive value in return. And "value," here, is unequivocally a "going concern" business that can continue to employ people and contribute to the tax base. 

But, first, the company (and Kirkland) had to deal with the Official Committee of Unsecured Creditors (UCC), a fiduciary body that represents all similarly-situated unsecured creditors in the bankruptcy process (read: most vendors, suppliers, customers, employees). Late Friday night the UCC filed its "Statement" in response to the company's motion. The statement expresses support for the company's proposed plan but ONLY after the UCC negotiated various changes to the extent and timing of the compensation sought. The UCC states, "[t]he Committee recognizes the importance of maintaining strong employee morale and ensuring that management and employees are collectively working towards the common goal of a successful holiday season and a strong and viable reorganized company." So, now, per the UCC's agreement with the company (and subject, still, to the UST and the Court), ONLY $16mm and $21mm will be payable to executives if "Target EBITDA" and "Stretch EBITDA" goals, respectively, are met. And the timing of payment has been altered as well, deferring and pinning greater amounts to the consummation of a reorganization. The UCC continues, "This feature...is particularly important to the Committee in the absence of a plan support agreement or defined business plan for the case, and in the face of the distinct business pressures imposed on retail companies in chapter 11." In other words, the UCC is worried about enriching execs only to see the company liquidate. And, given the state of retail today, they damn well should be - particularly since, we assume, the UCC has insight into how the business fared on Black Friday and Cyber Monday. Marinate on that.   

Lastly, permit us to issue you your weekly reminder that DIP Lenders justify the $3+b loan to Toys R Us on, what we now dub, a "there must be one" basis. In other words, "there must be one" bigbox toy retailer. Just like there is, you know, for sports (Dick's Sporting Goods ($DKS)) and books (Barnes & Noble ($BKS)). So, how IS the "one" doing in books? Well, BKS reported earnings this past week and it wasn't pretty. Sales were down 7.9%, comps were down 6.3% and earnings per share continued to trend deeper into the negative. But have no fear: the company has a creative and revolutionary go-forward strategy: "place a greater emphasis on books." Yup, you read that right. 

Will TOM SHOES Be Another Victim of Private Equity?

Is Blake Mycoskie's Company in Distress?

NPR’s “How I Built This” podcast featuring TOMS Shoes founder Blake Mycoskie is great. But it footnotes a big piece of the TOMS story and neglects another entirely: that Mycoskie sold 50% of the company to private equity firm, Bain Capital. And that the company has debt currently trading at distressed levels and faces a potential liquidity crisis.

Let’s take a step back. TOMS Shoes Inc. is an unequivocal success story and Blake Mycoskie is deserving of praise. He took an idea that was originally meant to be purely charitable and created a company that scaled from $300k of revenue in year one to $450mm in revenue in year seven. His "buy-one-give-one" model has resulted in millions without shoes now having shoes. And the model itself has been copied by Warby Parker, Bombas, and others, across various businesses. 

That said, for us, this tweet sparked a renewed interest in the company. Many have speculated for years that the TOMS story isn’t all rainbows and unicorns and that there are unintended consequences that emanate out of the one-for-one model. The report referenced in the tweet drives this point home. 

Why is this important now? Because the charity narrative is critical to TOMS. The company cannot afford for the public to sour on the message. Particularly since the company hasn’t been doing so hot lately. Revenue fell nearly 24% YOY in Q2 and EBITDA fell 72% YOY to $5mm. Cash is thinning and the leverage ratio is fattening. S&P downgraded the company back in August. The company's $306.5mm senior secured Term Loan is trading at distressed levels down in the mid 40s, a marked decline from the mid 70s in the beginning of ’17. And that is up from a week or so ago, when it was in the low 40s: this partnership with Apple ($AAPL) and Target ($TGT) helped pump the quote. For those who don't deal in the world of restructuring or distressed investing, a plunge of loan value by nearly 100% is, well, quite obviously a terrible sign. This means, plainly, that the market is pricing in the very real possibility that TOMS will default (and won't be able to pay back its loan in full). 

A positive? There are no near term maturities: the $80mm revolver is due in 2019 and the term loan is due in October 2020. Still, at Libor+550bps, the interest rate on the term loan is a minimum of 6.5% which is a cool $21mm in annual interest expense. And that’s before interest rates rise. The company looks like it will have trouble sustaining its capital structure and there’s no indication that the addition of new SKUs will help the company grow into it. With that interest expense, liquidity is going to get tighter. Those of you paying attention have heard this leveraged-buyout-gone-awry-lots-of-interest-expense story before: it’s the same one as Toys “R” Us, rue21, Payless Shoesource, & Gymboree. 

According to S&P, the wholesale business is feeling the trickle down effect of pervasively battered retail with inventory orders on the decline. In a thus far successful effort to maintain margin, TOMS is focusing on operational streamlining. We are guessing that some kind of financial advisor is in there (anyone know?). At a certain point, there are only so many costs you can take out of a business. Does anyone think the wholesale business is set to reverse course anytime soon given the state of retail? We don't. 

Which brings us back to NPR’s podcast. Celebrating how something is built is great and, again, we are big fans. The series has featured a variety of awesome episodes (email us for recs). But it bothered us that we weren't given the whole story. It's not sexy, we get that, but the company's debt load, interest expense, and private equity history should have been the last chapter. What comes next is to be determined. 

That Escalated Quickly: Toys R' Us Continues to Fade...

Distressed Investors and Private Equity Owners Seemingly Surprised

People can't seem to get enough of it and so we'll lead again with...you guessed it...Toys R' Us. Let's warm you up with a brief history lesson. Last week we speculated that supplier concerns were turning a stressed situation into a distressed situation. Looks like we may have been right. And so investors who may have been caught off guard are sending CDS coverage flying through the roof in an effort to hedge the value of rapidly declining debt holdings. Speaking of investors who may be worried...CMBS anyone? Now, rumors are that Alvarez & Marsal LLCand Prime Clerk LLC have been hired by the company to complement the previous retentions of Kirkland & Ellis LLP and Lazard Ltd. The smart money seems to think that that full array of professional retentions means a bankruptcy filing is IMMINENT. Alternatively, perhaps the public's newfound awareness of that full array of professional retentions means a bankruptcy filing is imminent. These things have a way of being self-fulfilling. Especially if vendors are paying attention. And it certainly seems like they are. Meanwhile, query what this all means for Vornado Realty Trust ($VNO). Sheesh. Anyway, we're old enough to remember when there was talk of an IPO. 

Geoffrey is on the Ropes: Toys R' Us is in Trouble

Private Equity Backed Retail is in the Dumps

"No Reason to Exist" - Restructuring Banker

Big news this week was CNBC's report that Toys R' Us hired Kirkland & Ellis LLP to complement Lazard ($LAZ) in a potential restructuring transaction.* This was followed by an S&P downgrade (firewall). This is "Death by self-commoditization," someone said. Sure, that's part of it but the more obvious and immediate explanation is the $5+ billion of debt the company is carrying on its balance sheet (and the millions of dollars of annual interest payments). Which, naturally, quickly gets us to private equity: KKR ($KKR), Bain and Vornado Realty Trust ($VNO) own Toys R' Us and so some are quick to blame those PRIVATE EQUITY shops for YET ANOTHER retailer hitting the skids. Post-LBO, this company simply never could grow into its capital structure given (i) the power of the big box retailers (e.g., Walmart ($WMT) & Target ($TGT)) and (ii) headwinds confronting specialty brick-and-mortar retail today (yeah, yeah, blah, blah, Amazon). That said, the gravity of the near-term maturity, the company's current cash position, and the bond trading levels don't necessarily scream imminent bankruptcy. There must be more to this. Speculating here, but this could just be an international value grab. Alternatively, given the tremendous amount of blood in the (retail) waters, we're betting that suppliers are squeezing the company. Badly. Like very badly. And/or maybe the company is trying to scare its landlords into concessions. We mean, seriously, we're in September. And the company is talking about bankruptcy NOW? Mere months from peak (holiday) toy shopping? Strikes us as odd. Someone has an agenda here. 

On a positive note, we want to give the company some credit: it tried its best to control the narrative by releasing its list of must-have toys for the holidays on the same day the Kirkland news "leaked."

*For anyone taking notes, this is a genius stroke of business development by Lazard: pinpoint a potential distressed corporate candidate and then poach that company's Vice President of Corporate Finance. Power. Move. We dig it.