Disruption from the Vantage Point of the Disrupted
Freemium Briefing - 10/10/18
Read Time = 5.9 a$$-kicking minutes
🗞News of the Week (2 Reads)🗞
1. 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.
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: firstname.lastname@example.org.
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2. Westmoreland Teaches Us About Coal (Long #MAGA!)
In our April piece entitled "🌑Trouble Brews in Coal Country🌑," we noted how Westmoreland Coal Company ($WLB) was headed towards a bankruptcy filing. Subsequently, in May, the company obtained a small round of financing ($90mm) to bridge itself to a chapter 11 bankruptcy filing. Alas, we're upon that filing — a “Chapter 33,” of sorts, for good measure.
And it’s an…interesting…one. The company’s First Day Declaration leads with “What is Coal” and then goes on to mansplain what coal is. It’s beautiful. It’s educational. It’s…odd. Per the Declaration:
Coal is a fossil fuel that forms from the remains of vegetation as long as 400 million years ago. The plants from eons ago captured energy through photosynthesis to create compounds (carbon) in plant tissue. When those plants and trees died, they ultimately sank to the bottom of swamps and formed a dense material called peat, which progressively carbonized under the earth’s pressure and changing temperatures and eventually became a combustible sedimentary and metamorphic rock, which is referred to as coal.
There are at least four ranks of coal, depending on the carbon content: lignite; subbituminous; bituminous; and anthracite. Some estimate that 90 percent of the coal in America is bituminous (i.e., soft) coal, which is primarily used to make electricity through combustion in boilers to make steam that is used to generate power (called steam or thermal coal) and coke for the steel industry (metallurgical or coking coal). The Debtors mine lignite, subbituminous, and bituminous coal.
We are thankful for the explanation. After all, there haven’t been many opportunities over the last decade to explore the intersection of coal and bankruptcy. Oh…wait. Hang on. Right. Ok, sure, there was Peabody Energy ($BTU). Ah, yeah, and Alpha Natural Resources. And Edison Mission Energy, Patriot Coal (x2), Walter Energy, Arch Coal ($ARCH), Xinergy, Armstrong Energy and James River Coal. To name a few. But we digress.
Anyway, THIS bankruptcy implicates Westmoreland (with affiliates, “WLB”), a thermal coal producer that sells coal to “investment grade power plants under long-term cost-protected contracts, as well as to industrial customers and barbeque charcoal manufacturers.” The company’s mines are located in Montana, North Dakota, Texas, Ohio and New Mexico, of which only 4 of a total of 23 are active. The company’s strategy generally revolves around focusing on coal markets where the company can leverage geographic proximity to power plants, some of which were specifically designed to use the company’s coal. Close proximity also permits the company to avoid onerous transportation costs, which, in turn, provides the company with flexibility to be a low(er) cost provider. There is a bit of an export business as well.
The problem is that “[t]he American coal industry is intensely competitive.” The company adds:
In addition to competition from other coal producers, the Debtors compete with producers of alternative fuels used for electrical power generation, such as nuclear energy, natural gas, hydropower, petroleum, solar, and wind. Costs and other factors such as safety, environmental, and regulatory considerations related to alternative fuels affect the overall demand for coal as a fuel. Political dynamics in the United States and Canada have additionally resulted in a reduction of the market demand for coal-based energy solutions.
Tack on a hefty chunk of debt:
And then mix in that the company is (i) subject to 7 collective bargaining agreements and, (ii) in addition to a multi-employer pension plan, that it also provides defined benefit pension plans to qualified employees — which, naturally, are underfunded by approximately $29mm and carry a termination liability of approximately $77.3mm. But wait, there’s more. The company also has, among other things, approximately (i) $1.3mm in retiree medical obligations, (ii) $18.2mm in federal regulatory Black Lung Act obligations, (iii) $334mm of “other post-employment benefit” obligations and (iv) asset retirement obligations of approximately $474.5mm. Why anyone would want to get into the coal business is beyond us. That all sounds outright depressing.
The company blames the following for its bankruptcy filing: (a) a challenging macro environment (⬇️ production and ⬇️demand); (b) a capital intensive business model; (c) the rise of natural gas as a lower cost alternative to coal (score one for the frackers!); and (d) regulation which, as you can see from the panoply of liabilities noted above, helps create a quite a heavy hitter lineup of economic obligations. Per the company:
When coupled with the external pricing pressure, increased regulation, political opposition to coal in the United States and Canada, and other costs associated with WLB’s businesses, these liabilities have hindered WLB’s ability to operate competitively in the current market environment.
And so the company has filed its chapter 11 bankruptcy with the consent of 76% of its term lenders, 57.9% of its senior secured noteholders and 79.1% of its bridge lenders to pursue a dual-track sale of its core assets to an entity to be formed on behalf of the senior secured noteholders and term lenders, subject to highest or best offers for the core assets at an auction. The sale will be consummated through a plan to, among other things, preserve tax benefits. The company will also continue to market its non-core assets. Likewise, the master limited partnership 94% owned by the company (“WMLP”) is for sale. Notably, with no prospect of a restructuring on the horizon, there is no deal in place with the unions and retirees and WLB may have to proceed on a non-consensual basis.
The company marched in to court with a commitment for a $110mm DIP. It will roll-up the bridge loan and fund the cases while the sale processes progress.
**Case roster here.
We have compiled a list of a$$-kicking resources on the topics of restructuring, tech, finance, investing, and disruption. 💥You can find it here💥. Two books we’re excited to add to the list include Bethany McLean’s “Saudi America” and Gary Shteyngart’s “Lake Success.” The former is about the U.S. as a world oil superpower and the latter is apparently about how hedge funders are d-bags.
😎Notice of Appearance😎
This week we welcome a Notice of Appearance by J. Scott Victor, a Managing Director at SSG Capital Advisors LLC, a boutique investment bank based in Philadelphia. We edited the dialogue lightly for content and length. Enjoy.
PETITION: You've carved out a niche in the middle market. What is your assessment of distress in the middle market today and what may we expect in that area in the next 6-9 months?
There is always distress in the middle market. Regardless of the macroeconomic environment there are universal constants: undercapitalization, too much debt, poor management decisions, sales declines, lack of margin control, excessive expense structure. I could go on and on – all resulting in a steady stream of distressed middle market companies.
From multi-generational family-owned or single owner and operator businesses with inadequate systems and not enough equity capital to PE portfolio companies leveraged to the hilt with debt to VC-backed and public bleeders that have been startups for a decade or more burning through tens to hundreds of millions to failed rollups, the distressed middle market has it all including real industry-specific Disruption. These beloved underperformers are in every industry and every region of the country and while they aren’t generally big enough names to warrant coverage in Petition, they provide an abundance of work for middle market professionals.
Nothing will change in the next 6-9 months. There is an incredible amount of debt capital from an ever increasing number of lenders – bank and non-bank ABLs and cash flow lenders, BDCs, commercial finance companies, factors, equipment and real estate lenders. The better underperformers will continue to be refinanced out of their existing bank lenders and live to sink or swim next year. The rest can expect §363 sales, Article 9’s, ABCs, receiverships, or straight-up liquidation. It’s economic Darwinism at work.
PETITION: What is one thing that most needs changing in order for middle market clients to get the most they can out of an in-court bankruptcy proceeding?
Don’t get me started on this one! Chapter 11 is too expensive and lower middle market companies can’t afford it. More importantly, the lenders for the smaller borrowers don’t want to pay for it. Thus the rise of Article 9’s, ABCs and state court receiverships being utilized for smaller transactions. Almost every one of my Chapter 11 cases has two sets of counsel, a financial advisor, an investment banker, and a claims agent and that’s just for the debtor. Factor in two sets of counsel and a financial advisor for the creditors committee and another two sets of counsel and financial advisor for the lender(s) and that’s before any other professionals such as real estate advisors, special counsel, liquidators and independent board members. And, don’t forget the new UST fee schedule! The fee burden on debtors is often why there’s rarely ever a meaningful distribution to unsecured creditors. I know I’m preaching to the Petition choir, but Chapter 11 just costs too much.
PETITION Note: See #1 above if you skipped the end.
PETITION: We've written a lot recently about the decline in L. Brands' Victoria's Secret ($LB) line and the rise of direct-to-consumer and celebrity-backed (i.e., Rihanna) brands. You did the Peekay Acquisition LLC bankruptcy. What lessons did you learn there that may apply to L Brands and other legacy lingerie brands that are currently under attack?
I learned that sexual health and well-being is a very good thing! Peekay was too small to be public and had way too much debt resulting from a poorly-implemented roll-up strategy. Victoria’s Secret has numerous issues including deteriorating product quality resulting from revolving manufacturing facilities around the world and an underwhelming yet distracting customer store experience that a huge marketing spend can’t fix. Insta-friendly celebrity brands, including lingerie and cosmetics are trending, but their sustainability is ultimately tied to quality, buying experience and the celebrity quotient.
PETITION: What is the best piece of advice that you’ve been given in your career?
My first legal mentor told me that practicing lawyers will make a good living, but never be rich. My second legal mentor told me to become an investment banker. My investment banking mentor told me to dress well and to drink heavily. I take advice well.
PETITION: What is the best book you’ve read that’s helped guide you in your career?
Two books: The 1st edition of Peter and Wendy by J.M. Barrie – the opening line “All children, except one, grow up.” I say no more.
Hostile Witness by William Lashner. Bill was a colleague at my first law firm in the mid-80’s and the son of my legal mentor. He left the firm to become a writer. I am Victor Carl.
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