the Toys R Us Chapter 11 filing

Toys R Us (TRU) is no longer a publicly traded company.  After a very rocky period of being buffeted by Wal-Mart, Target, and with Amazon beginning to pile on, TRU was taken private in 2005.

Its fortunes haven’t improved while in private equity hands.  In addition, as private equity projects usually do, TRU acquired a huge amount of debt, as well.  In a situation like this, suppliers are typically very antsy about the possibility of a bankruptcy filing.  That’s because trade creditors have little standing in bankruptcy court; they usually can’t get either their merchandise back or payment on any receivables due.

When a reent press report appeared that TRU was considering Chapter 11, suppliers apparently refused to send any more merchandise to TRU on credit, demanding payment in full upfront instead.  The company didn’t have the cash available to pay for enough merchandise to fill its stores in advance of the all-important holiday season.   So it filed for Chapter 11 bankruptcy.

None of this is particularly strange.  Years ago, one of my interns did a study that showed that even in the early 1990s TRU was losing market share to WMT and TGT, and was making due mostly by taking share from mom and pop toy stores.  Then the last mom and pops closed their doors and TRU’s real trouble began.

What dd surprise me was the report in today’s Financial Times that the company’s notes due in 2018 were trading at close to par a couple of weeks ago–vs. $.28 on the dollar now.

How could this be?  Holders were apparently betting that TRU would limp through the holidays and then refinance its 2018 debt obligations–allowing these “investors” to collect a coupon and exit if they so chose.

The fact that professional investors would commit money to this threadbare investment thesis shows how desperate for yield they are in fixed income land at present.  As/when rates begin to rise, things could easily get ugly, fast.

Caesars Entertainment and private equity

I’ve been wanting to write about what might be called the private equity paradigm for some time. On the other hand, I don’t see any way for me as a portfolio investor to make money from research I might do–other than to keep as far away from private equity deals as possible–so I haven’t done as meticulous job of research on this post as I would if it involved a stock I might buy.  So regard this more of a preliminary drawing than as a finished picture.

When a private equity firm acquires a company, it seems to me it does five things:

–it cuts costs.  The experience of 3G Capital seems to show that typical mature companies are wildly overstaffed, with maybe a quarter of employees collecting a salary but doing no useful work.  Private equity also uses its negotiating power to get better input pricing, although it passes on little, if any, of the savings

–it levies fees to be paid to it for management and other services

–it increases financial leverage, either through taking on a lot of bank debt, or, more likely, issuing huge swathes of junk bonds.  An equity offering may happen, as well

–it dividends lots of available cash generated by operations and/or sales of securities to itself, thereby recovering much/all of its initial investment

–it then sits back and waits to see whether (mixing my metaphors) this leveraged cocktail to which it now has only limited financial exposure, sinks or swims.

 

Caesars Entertainment has added a new twist to this paradigm.  In 2013, its private equity masters seem to have decided that sink was the more likely outcome.  Rather than simply accept this fate, they began preparing a lifeboat for themselves by whisking away valuable assets from the subsidiary that is liable for the company debt into another one.  In January 2015, after this asset shuffling was done, they put the debt-laden subsidiary into bankruptcy.

Junk bond holders sued.  Litigation has been protracted and has reportedly cost $100 million so far.

Media reports indicate that the case is now approaching resolution–either through negotiation or court ruling.  My no-legal-background view (I was a prosecutor in my early days in the Army, but that says more about the Uniform Code of Military Justice back then than about me) is that:  these asset transfers can’t be legal; and the junk bond loan agreements should have had covenants that explicitly bar such action.  So I’m not sure what has taken this long.

Whatever the outcome of the case is, I think it will shape the nature of private equity from this point forward.

 

 

 

inheritance tax changes as a lever for structural change in Japan

value investing and corporate change…

One of the basic tenets of value investing in the US is that when a company is performing badly, one of two favorable events will occur:  either the board of directors will make changes to improve results; or if the board is unwilling or incapable of doing so, a third party will seize control and force improvements to be made.

…hasn’t worked in Japan

Not so in Japan, as many Westerners have learned to their sorrow over the thirty years I have been watching the Japanese economy/market.

Two reasons for this:

culturally it’s abhorrent for any person of low status (e.g., a younger person, a woman or a foreigner) to interfere in any way with–or even to comment less than 100% favorably on–a person of high status.  So change from within isn’t a real possibility.

–in the early 1990s, as the sun was setting on Japanese industry, the Diet passed laws that make it impossible for a foreign firm to buy a large Japanese company without the latter’s consent–which is rarely, if ever, given.

The resulting enshrinement of the status quo circa 1980 has resulted in a quarter century of economic stagnation.

Abenomics to the rescue?

Abenomics, which intends to raise Japan from its torpor, consists of three “arrows”–massive currency devaluation, substantial deficit government spending and radical reform of business practices.

Now more than two years in, the devaluation and spending arrows have been fired, at great cost to Japan’s national wealth–and great benefit to old-style Japanese export companies.  But there’s been no progress on reform.  The laws preventing change of control remain in place.  And there’s zero sign that corporations–many of whose pockets have been filled to the brim by arrows 1 and 2, are voluntarily modernizing their businesses.  Mr. Abe’s failure to make any more than the most cosmetic changes in corporate governance in Japan is behind my belief that Abenomics will end in tears.

One ray of sunshine, though.

Japan raised its inheritance tax laws at the end of last year, as the Financial Times reported yesterday.  The change affects three million small and medium-sized companies.

The top rate for inheritance tax is 55%, with payment due by the heir ten months after the death of the former holder.   This development is prompting small business owners to consider how to improve their operations to make their firms salable in the event the owner dies.  More important, it’s making them open to overtures from Western private equity firms for the first time.  Increasing competition from small firms may well force their larger brethren to reform as well.

For Japan’s sake, let’s hope this is the thin edge of the wedge.

 

 

Detroit’s city-owned art and alternative investments

Late last year, Detroit revealed the results of an estimate by auction house Christies of the value of the city’s art held by the Detroit Institute of Art.  The figure was a range of $464 million – $867 million.  Let’s take the mid-point and call it $650 million.

Yesterday, I saw in the Wall Street Journal a new estimate by Artvest Partners and commissioned by the city that comes in with a range of $2.8 billion – $4.6 billion.  The mid-point here is $3.7 billion.

But wait!   …there’s more.  According to Artvest, if Detroit actually wanted to sell the artwork, it’s only worth $850 million – $1.8 billion.  Mid-point:  $1.3 billion.

OK, which is it—$650 million, $1.3 billion or $3.7 billion?

There is one subtlety.

–The $650 million is the (if you’re not selling) value of the art that the city has bought with its own tax money.  It does not include work donated to the DIA, where there may be strings attached that don’t allow the works to be sold.  (An aside:  there may be a further twist here.  The DIA has presumably either provided donors with appraisals of their gifts’ value, or validated appraisals donors have provided.  In either case, donors will have used these figures, which may be–shall we say, “optimistic”–to claim income tax deductions.  a potential mess that I have no desire to comment further on.)

–The Artvest figures, on the other hand, count everything as salable.

What caught my eye in the WSJ article is the gigantic difference between what the appraiser says the art collection is worth–$3.7 billion–and what it would fetch at auction–about a third of that amount.

What struck me is that this is a lot like the way, in my experience, that the market for illiquid “alternative” assets works.  So the Detroit case gives a rare glimpse into the inner workings of alternative asset valuation.

As in the Detroit case, there’s one value that investors hear about in reports from the management company, and based on which the manager charges his fees.  That, of course, is the $3.7 billion.

The other value is what investors would get if the alternative asset pool were to be liquidated today.  It’s what mutual fund investors would call net asset value, or NAV.  That’s the equivalent of the $1.3 billion.

Yes, part of the reason the actual sales value in the Detroit case is so far below the (I don’t know what to call it) “dream” value of the artwork is the possibility of donor litigation that would freeze assets for protracted periods.  On the other hand, any investor in emerging countries can face similar political difficulties.

Several factors do make the alternative investment case different from Detroit’s:

–in at least some alternative investment situations I’ve seen, the assets are so esoteric that there are few experts other than the asset managers themselves.  So the managers end up doing the asset value appraisals.  If so, I think they’ll tend to find it hard to arrive at a figure that’s not in the rarified air of Artvest’s $3.7 billion.

–the contracts between investors and managers often allow the latter to refuse redemption requests for an extended period, so actual NAV may be a moot point.

–if investors insist on liquidation, asset managers may be able to make a distribution in kind–meaning investors get their proportionate share of the actual assets, not cash.

Institutions will do almost anything to avoid this situation, since they’ll be forced to safeguard and value any assets they receive.  (Early in my career, when Guinness was an independent company, some one there had the crazy idea of paying a dividend in bottles of scotch instead of cash.  This would make portfolio managers like me responsible for valuing and storing the stuff, and presumably eventually selling it, on behalf of my clients.  What a disaster!)

–based on NAV, it’s not 2% of the assets per annum that moves from the investors’ pockets into the managers’.  It’s actually 6%!  Ouch.

As I’m confident you’ve worked out already, I’m not a fan of alternatives.  The risks are hard to get your arms around; information is scanty; and in my view most of the returns go to the managers.  Investors mostly get to dazzle their cocktail party friends with their daring; they lick their wounds in private.

My thoughts aside,for anyone wanting to get a peek under the covers of alternatives, watching the Detroit art case should provide an education.

 

 

 

 

 

institutions reacting to poor hedge fund/private equity returns

A couple of days ago, the Dealbook section of the New York Times reported on a recent meeting of the Institutional Investors Roundtable in western Canada.

The purpose of the organization, founded in 2011, is to help large government-linked investment bodies, like sovereign wealth funds and managers of government employee pension plans, cooperate to solve common problems.

According to the NYT, the agenda of the latest meeting was hedge fund and private equity investments.  Although the proceedings are secret, it doesn’t take a genius to figure out what went on.

The institutions’ dilemma:  on the one hand, they want and need the diversification and the high-return investment opportunities that hedge funds and private equity promise.   On the other, despite their colorful brochures and persuasive presentations, many hedge fund/private equity ventures produce pretty awful returns.

There are two main reasons for this:

–some hedge fund/private equity operators are brilliant marketers and well-connected politically, but that’s it.  They’re not great investors.  It doesn’t help matters that academic research shows a significant number of them bend the truth in stating their qualifications, track records, assets under management…

–the hedge fund/private equity fees are so high that there’s little extra return left over for the institutions who supply the investment capital.

The IIR solution?

It’s to try to develop hedge fund/private equity projects among the members themselves, thereby cutting out the fees charged by third parties.  One institution cited in the NYT article says doing so adds 5 percentage points to the annual returns it received from such projects.  On a world where bonds yield next to nothing and where stocks may produce 6%-8% annual returns, a 5 percentage point pickup is enormous.

This movement is in its infancy.  Not every institution will be able to participate, either because of political pressure at home or lack of even minimal expertise.  But even that may change in time.

The most important thing to notice, I think, is the evolution away from traditional Wall Street practices that make the financiers–and no one else–rich.  I think that sovereign wealth funds, bot from China and the Middle East, will take leading roles in this development.

Blackberry (BBRY)’s search for strategic alternatives

a 6-K

Yesterday BBRY filed a 6-K (it’s a foreign–i.e., Canadian–company, hence it’s a 6-K, not an 8-K) with the SEC, which consists of the press release it issued at the same time.

In it, BBRY (BB for you Toronto Stock Exchange fans) says it’s setting up a committee to explore strategic alternatives, which the firm defines as “possible joint ventures, strategic partnerships or alliances, a sale of the Company or other possible transactions,”

BBRY also says the board member, Prem Watsa, CEO of BBRY’s largest shareholder, investment firm Fairfax Financial, has resigned from the board citing “potential conflicts” that may arise as the committee does its work.

What’s going on?

It seems to me that BBRY effectively hung a “For Sale” sign around its neck in March 2012–and has had no takers.  So the announcement appears to mean–and is being widely taken on Wall Street as meaning–that BBRY is getting ready to go private.  Mr. Watsa’s resignation from the board suggests his firm will want to be part of the private ownership group.

Why go private?  

Why can’t BBRY do what’s necessary while retaining its listing?  It’s all about financing.

1,  For one thing, it’s better to have no price than a low price.

BBRY may need radical surgery to survive.  Contrary to the picture presented in finance textbooks, Wall Streeters aren’t steely eyed rational thinkers.  The sight of blood and body parts on the operating table makes them woozy.  During restructuring, the stock price might decline–sharply, very sharply.  Professional short-sellers, whose job is to kick a fellow while he’s down, would certainly help push the price down.

The low price–let’s say $1 a share vs. about $11 now–has several bad consequences.

–It scares the wits out of potential sources of finance, either the junk bond market or commercial banks, who would take the same factual situation much more calmly if there were no plunging price chart.  This effectively cuts off liquidity, just as the firm needs it the most.

–The price could get low enough that the stock is delisted, another unnecessary black eye.

–Worst of all for shareholders, a stock that’s unattractive to acquirers at $11 may become irresistible at $2.  Shareholders might jump all over a takeover bid at $4–in effect “stealing” the patient right out of the recovery room.

2.  Look at DELL.  Silver Lake has lots of experience in turning around tech companies.  Its price?  …ownership of the company, i.e., the lion’s share of the profits from doing so.  That’s just the way it is.

3.  One of the ugly secrets of private equity is this:  sometimes, when the private equity owners sense the ship is sinking despite their best efforts, they make a large junk bond offering and pay out some or all of the proceeds as a dividend to themselves.  Their risk is lessened by the return of capital; that of the offering company is increased.  This maneuver would be impossible to accomplish with a publicly listed company.

4.  Yes, going private frees management from SEC-mandated financial disclosure and from the need to do extensive investor/press relations.  But I think this is a minor benefit in comparison with either #1, #2 or #3.