Friday Workout

Food for thought; Opco/PopCo; What’s the story - reopening glory?

By Chris Haffenden | Editor | chris@9fin.com

Here at 9fin Towers we are in the thick of the action – covering a rampant High Yield bull market – as yields push towards record lows (and that’s before your real returns are wiped out by inflation). With at least five deals launching each Monday and with Credit, Legal & ESG QuickTakes to produce for each, plus relative value chart discussions, sometimes it can be difficult to see the bigger picture.

But zooming out (no covid-pun intended) is certainly worthwhile. Where are we heading?

Is there a cliff edge?  Are there any signs of top of the market activity?  

We are tracking a few likely metrics: HoldCo PIK, CCC-rated deals, dividend recaps, shortening of call protection, covenant deterioration, upsizes, stressed refinancing, higher leverage and aggressive EBITDA add backs. Watch this space for more insights from 9fin in coming weeks.

History never repeats itself, but it rhymes. Unlike many analysts in the LevFin community, I have some first-hand experience of several credit market busts, most notably the GFC. Almost inevitably I’m drawn to comparisons to the boom in LevFin in 2006/2007 for clues for the next downturn. 

Back then, there was a lot of financial engineering, with bankers and sponsors seeking to find innovative ways of adding more leverage, to keep Chuck Prince and his pals dancing. 

These were the heady days of the OpCo / PropCo financings, and securitisation of pubs, hospitals as LevFin bankers wanted to ride the commercial real estate wave. They were not only willing to underwrite senior and mezz, but also wanted a slice of the equity too. Remember HBOS Integrated Finance? The Parliamentary Commission on Banking Standards Report is a great place to start

For students of European LevFin it is worth looking back at some of these deals, many are now reappearing as European High Yield issuers. A good example is David Lloyd, which was part of the HBoS Integrated Finance Portfolio in 2007, alongside other names such as Vue Cinemas. 

David Lloyd was acquired as a property play by London & Regional for around £930m, reportedly for a 13.4x EBITDA multiple. The equity cheque was minimal, with an OpCo/PropCo structure mooted, presented to banks a year later in July 2008 as £183.75m of Opco (around 2.6x levered) and £611.95m of PropCo debt (including £138.1m HoldCo PIK). But the response was muted, with HBoS eventually forced to take the £850m bridging loan onto its books. 

TDR Capital acquired David Lloyd for £750m in 2013, funded by a £500m unitranche loan from hedge fund TCI. In 2015, TDR came back with a dividend recap (my former Debtwire colleagues revealed attempts to sell down exposure in 2014 to property funds) including a £120m second lien. It was a tough sell with the OID reduced to 96 from 99 to get it away, with Ares reportedly taking the sub debt. 

Just two years later the business was put up for sale for £1bn to £1.3bn. But buyer and financier interest were tepid, and it was only recently that it was able to take advantage of a hot market to sell £645m of fixed high yield at 5.5%, and €300m of FRNs (E+475bps) based on pre-pandemic adjusted EBITDA plus £20.8m of ‘existing portfolio run-rate adjustments.’

Punch Taverns is another remnant of the OpCo/PropCo era, whose pre-crisis securitisations were restructured in 2014 and have eventually found their way to High Yield to take out the remainder. Peer Stonegate still has some outstanding securitisations, but plain vanilla HY now appears to be the most attractive route for PubCos to issue. Asset-coverage is still touted as a key selling point for investors, but bankers appear less willing to use these assets to boost leverage. 

Food for thought

So, news of investor fears that Fortress would be monetising Wm Morrisons property portfolio in its £6.75bn acquisition gives food for thought. 

Without irony (the insurer is one of the UK’s largest commercial investors) Legal & General Investment Management warned that it should not be sold for the wrong reasons: 'It should not come from buying its property portfolio too cheaply, levering the company up with debt, and potentially reducing the tax paid to the Exchequer.'

Robert Tchenguiz’s disastrous investment in Sainsbury’s springs to mind as a cautionary tale. One of my reporting team was onboard his yacht in Cannes for the 2011 MIPM property conference as an invitee to one of his infamous boat partiesbut the Tchenguiz brothers failed to arrive, after they were detained after a dawn raid at their Mayfair homes by the Serious Fraud Office, in full view of TV cameras earlier that day. 

They later successfully sued the SFO for damages. But the settlement was a drop in the marina for Robert, forced to sell his 10% Sainsbury stake for less than half he paid for it.  

So why are private equity firms so excited about Supermarkets? 

EG Group might be showing the way for Fortress with their ASDA acquisition. React News recently reported that Blackstone Group has agreed to buy 25 ASDA warehouses for £1.7bn, then leased back to ASDA. If executed, this would mean that the Issa Brothers and TDR can repay themselves a special dividend easily covering their initial equity cheque. 

Wm Morrison took a £1.27bn impairment to its property assets in 2015. But during the past two years demand for supermarket properties has soared. The Times speculates that the property assets may be severely undervalued, saying that they could be worth £9bn, double their current book value. 

But as Neill Keaney from Creditsights tweeted in response: “ASDA property market valuation on 20 October last year was £9.3bn yet Walmart sold it for £6.8bn. Banks have traded below their book value for years. Could it be that applying an opco/propco valuation just doesn't work for MRW or indeed, ASDA, SBRY, TSCO etc...”

I don’t necessarily have an issue with monetising property value from Supermarkets, there is stability of revenues and upside potential from out-of-town stores that can become delivery and storage hubs. But elsewhere in retail it is a lot tougher. As Intu has shown, changes in the retail landscape and new shopper behaviours can have significant impact on their retail tenants and consequently on commercial real estate valuations. 

Don’t forget, calculating the value of commercial property is a combination of factors – a multiple of implied rental yields discounted to reflect lease length and tenant creditworthiness.

What’s the story, Reopening glory? 

Pizza Express doesn’t own any of their restaurants, sadly there are no PropCo assets to leverage. 

Therefore, their new fund owners which took control last October in return for halving of the debt burden in a restructuring, need another narrative to attract investors into their new High Yield bond, the latest in a series of stressed refinancing deals. 

As an Emerging Markets trader, I learned an important lesson from gnarled and battle-weary HY veterans when subsumed into the High Yield group. Yes, fundamental and credit analysis was important, but what buyers really want is a story, they said. It’s all about turnaround, alternative angles, what everyone else is missing or misvaluing. Get this right and buy orders would flow. 

For Pizza Express and a number of recent High Yield deals, the narrative is reopening and companies benefiting from pent-up demand after transforming their business during lockdown. 

Pizza Express made a dig in their NetRoadshow materials at former owner Hony Capital and their disastrous investment in Chinese expansion and alleged poor stewardship. HY investors are buying into Pizza Express 2.0, under new impressive management, such as CEO Jinlong Wang, the former Wagamama CEO, and the former ASDA CEO and Co-op Chairman Alain Leighton as Chair.

The new hedge fund owners have been busy, closing down unprofitable restaurants, reducing rents, and are hoping that branded products such as Pizza Express uncooked dough in Supermarkets (am I alone in not finding this unappetising?) will drive revenues. Management says it also stands to benefit from the financial difficulties from peers such as Prezzo and Zizzi. (I may be an outlier, but I find that many pubs now produce much better pizza, and you can get a decent beer to go with it.)

Pizza Express was struggling prior to Covid to grow revenues. As we reopen higher input costs, and well publicised staff shortages in the hospitality industry will inevitably lead to higher wage costs. From an ESG perspective, staff treatment was already a red flag, as our ESG QuickTake outlines Pizza Express reduced the level of tips to staff since reopening with underpayment of minimum wages subject to an HMRC investigation in 2018. Our ESG investigation discovered their website’s environmental policy link doesn’t work. 

Documentation also suggests a keenness for its new fund owners to flip their dough once the financial toppings (using 2019 EBITDA figs plus operational adjustments) are cooked. Portability is at opening leverage, with unrestricted subsidiaries explicitly able to transfer value as PI without being deemed an ‘indirect’ RP coupled with what our analysts say is a somewhat weak J Crew blocker. 

Tomorrow never knows what it doesn’t know too soon

Price talk for Pizza Express’ looked cheap if you believed the reopening story and the reported 3.8x net leverage – at low to mid-7s, eventually coming in to 6.75%, still a premium to reopening peers Punch, Pure Gym and Stonegate, which have all traded strongly in secondary. 

With funds seemingly addicted to a regular injection of formerly toxic names, waiting confirmation of future business performance is less of an issue. They may need a little time to wake up and pass on the initial yield hit. I am confident a number of current transactions will be wasted in the next two to three years. Assumptions for many deals are too strung out, coming down from this high will hurt.

Unlike 2006/07, banks are unlikely to be on the hook, the originate to distribute model still predominates, their balance sheets are strong, and exposure to leverage finance much lower. 

There is less financial engineering, but the innovation is seen in financial accounting and legals.

High transaction multiples and big equity cushions are supportive. But what happens when sale multiples start to contract? How will sponsors extract value when appetite for leverage diminishes? Especially as all the reporting and pricing has baked in expected business performance gains. 

Remember, actual leverage is higher than you think – many deals are marketed with add backs of 25% or more for future savings – with the starting point often a highly adjusted EBITDA figure.  

Investors should be looking closely at the documents and forensically look through the financials – much easier using the 9fin platform, by the way. Covenants are eroded to the point that one savvy fund manager told me, that they now protect the companies and the sponsors, not the investors. 

I recommend a close eye on developments in the US for clues on what could happen here.

Last week was the launch of Intralot’s aggressive restructuring proposal, the first in Europe to use a drop-down Unrestricted Subsidiary finance structure, used by J Crew in the US last year. More details are available in our Restructuring QuickTake, published on Monday. 

Led by the 2021 notes, the restructuring plan provides disparate treatment to the 2024swhich are ranked pari passu. The €250m senior notes due September 2021s are to be exchanged for new $244.6m senior secured notes due 2025, to be issued by its US subsidiary Intralot Inc. 

The 2024s however, are primed, being offered just a partial exchange into 49% of Intralot Inc equity, and to avoid breaching restrictions on secured/priority debt incurrence, Intralot intends to designate the new US topco and its subsidiaries as Unrestricted Subsidiaries, resulting in the US group no longer being subject to 2024 notes restricted covenants, triggering the release of the 2024 Notes guarantee from Intralot Inc, the issuer of the 2025 notes. 

As we revealed earlier this week, the 2024s have hired litigation counsel. There are far reaching implications for other names, and therefore holders cannot allow the land grab, they explain. Litigation funders and hedge funds with legal strategies have recently approached holders. With the bonds governed by New York law, the US is the most likely litigation forum. 

The either/or baskets language to establish capacity, and ‘all or substantially all’ arguments that would trip change of control covenants are their main points of contention. Our analysis suggests an uphill challenge, but faced with litigation, there may still be a deal to be done with the 2024s. 

What we are watching/reading this week

ELFA members got a look under the hood at the 9fin platform yesterday. The presentation was recorded, so if you missed out, please contact team@9fin for more details

Earlier this year, after the UK failed to secure a replacement to the EU recast judgments recognition, many lawyers tipped that more restructurings would head to the US. I will be getting these blown up to poster size and put on the walls of our newsroom

Royal Caribbean is contender for headline of the week - Celebrity Flora Fulfills Long-Awaited Bucket-List Moments for Wanderlust Travelers as Celebrity Cruises Returns to the Galapagos Islands. But the disclaimer – for forward looking statements – is way too long for the Workout.

The UK is keen to maintain financial services and attract business post Brexit, but as the FT’s Cynthia O’Murchu reveals it’s no joke, when their home according to Companies House is shared with a Russian in his mid-forties, evicting their virtual squatter was complex and costly

Natixis Global Investor survey makes for disturbing reading. No, they are not bearish, but their expectations on returns are crazy high. After capturing returns of 12.5% above inflation in 2020, investors anticipate even higher returns post-pandemic markets: For 2021 they expect to achieve annual returns of 13% above inflation. Over the long term, they anticipate 14.5%. 

This week there was contradictory messages from equity and bond markets, with stocks at ATHs and 10-Year US Treasury yields falling sharply

Earlier this week Callum Thomas asked if this chart was Spring-board? or Diving-board?

At time of publication – I would say Diving board - the 10-year is yielding 1.33% after hitting 1.24% at one point

My former colleague Jim Reid at Deutsche says there’s a serious debate about what’s driving these rates moves. “On the one hand, there’s a case that this is driven by fundamentals, with our head of FX Research George Saravelos supporting the view that this rally is coming about because markets are increasingly re-pricing secular stagnation themes again after the pandemic. We looked at the supply and demand for treasuries and found that on a rolling 3-month basis the entire net supply of treasuries had recently been taken down by the Fed on a net basis. This is extremely rare even in a QE world and also remarkable given it coincided with the biggest fiscal giveaway in history.” 

Dr Doom - Nouriel Roubini, might have the answer – a looming stagflationary debt crisis.“Years of ultra-loose fiscal and monetary policies have put the global economy on track for a slow-motion train wreck in the coming years. When the crash comes, the stagflation of the 1970s will be combined with the spiraling debt crises of the post-2008 era, leaving major central banks in an impossible position.”

Finally, I miss the regular London Restructuring Club get togethers with funds and advisors from the last crisis, hopefully it will make a return for the next. But in the meantime, a plug for the Dutch version