The Credit Cycle, Q1 Review Cont. & Moelis & Company
|Apr 25||Public post|
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Midweek Freemium Briefing - 4/25/18
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ICYM Sunday’s MEMBER Briefing:
In our Members’-only Sunday briefing “‼️Pension Crises Abound‼️” we completed our pet trilogy (Philips, Petsmart, Petco) just in time for Petsmart to report earnings. We also discussed Q1’s most successful company-side financial advisor, the credit cycle, crowdfunding, Guitar Center, pension crises, coal and more. Did you miss it? Become a member by clicking on that little blue button below.
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News of the Week (4 Reads)
1. What to Make of the Credit Cycle (Part 4)
We’ve spent a considerable amount of space discussing what to make of the credit cycle. Our intent is to give professionals a well-rounded view of what to expect now that we’re in year 8/9 of a bull market. You can read Parts one (Members’ only), two, and three (Members’ only), respectively.
Interestingly, certain investors have become impatient and apparently thrown in the towel. Is late 2019 or early 2020 too far afield to continue pretending to deploy a distressed investing strategy? Or are LPs anxious and pulling funds from underperforming or underinvested hedge funds? Is the opportunity set too small - crap retail and specialized oil and gas - for players to be active? Are asset values too high? Are high yield bonds priced too high? All valid questions (feel free to write in and let us know what we’re missing: email@example.com).
In any event, The Wall Street Journal highlights:
A number of distressed-debt hedge funds are abandoning traditional loan-to-own strategies after years of low interest rates resulted in meager returns for investors. Some are even investing in equities.
PETITION Note: funny, last we checked an index fund doesn’t charge 2 and 20.
The WSJ continues,
BlueMountain Capital Management LLC and Arrowgrass Capital Partners LLP are some of the bigger funds that have shifted away from this niche-investing strategy. And lots of smaller funds have closed shop.
A number of smaller distressed-debt investors have closed down, including Panning Capital Management, Reef Road Capital and Hutchin Hill Capital.
PETITION Note: the WSJ failed to include TCW Group’s distressed asset fund. What? Too soon?
We should note, however, that there are several other platforms that are raising (or have raised) money for new distressed and/or special situations, e.g., GSO and Knighthead Capital Management.
Still is the WSJ-reported capitulation a leading indicator of increased distressed activity to come? Owl Creek Asset Management LP seems to think so. The WSJ writes,
Owl Creek founder Jeffrey Altman, however, believes that if funds are shutting down and moving away from classic loan-to-own strategies then a big wave of restructuring is around the corner. “If anything, value players leaving credit makes me feel more confident that the extended run-up credit markets have been enjoying may finally be ending,” Mr. Altman said.
One’s loss is another’s opportunity.
Speaking of leading indicators(?) and opportunity, clearly there are some entrepreneurial (or masochistic?) investors who are prepping for increased distressed activity. In December, The Carlyle Group ($CG), via its Carlyle Strategic Partners IV L.P. fund, announced a strategic investment in Prime Clerk LLC, a claims and noticing administrator based in New York (more on Prime Clerk below). Terms were not disclosed — though sources tell us that the terms were rich. Paul Weiss Rifkind & Wharton LLP served as legal counsel and Centerview Partners as the investment banker on the transaction.
On April 19th, Omni Management Group announced that existing management had teamed up with Marc Beillinson and affiliates of the Beilinson Advisory Group (Mark Murphy and Rick Kapko) to purchase Omni Management Group from Rust Consulting. Terms were not disclosed here either. We can’t imagine the terms here were as robust as those above given the market share differential.
The point is: some opportunistic folk sure seem to think that there’s another cycle coming. And they’re putting their money where their mouth is, thinking that there will be money to be made in the (seemingly saturated) case administration business. Time will tell.
2. What to Make of the Credit Cycle (Part 5): Moelis & Company Pounds Chest
In the meantime, those who can leverage robust M&A activity will. But let’s take a step back…
Do you remember THAT scene in the “Wolf of Wall Street?” The one where Leo and Matty-C pound their chests in the most bro-ey of bro-ey banker moments…? We’re pretty sure this is what the bankers over at Moelis & Company ($MO) were doing before, after and as they were announcing earnings on Monday.
Take this quote for instance:
Analyst: “Ken, I still get plenty of investors that mispronounce the name of your firm, so I guess we’re still working on it.”
Ken Moelis: “There is no mispronunciation, there’s only a wrong phone number. If they get the phone number right….”
Kind of hard to argue with that. Who gives a crap how your name is pronounced if the phone is ringing, the rates are increasing and the dollars are coming in? Marlo Stanfield’s “My name is my name” proclamation in the final season of The Wire clearly doesn’t apply to Ken Moelis. Have to admire that.
So, right after we gave Evercore ($EVR)(which reports earnings today) and PJT Partners ($PJT) props in our Q1 review of bankers (to be fair: covering company-side only), Moelis dropped these numbers:
We achieved $219 million of revenues in the first quarter, up 27% over the prior year. This represented our highest quarter of revenues on record. Our performance compares favorably to the overall M&A market in which the number of global M&A completions greater than $100 million declined 14% during the same period. Our growth was primarily attributable to very strong M&A activity in the quarter. We're participating across industries and deal sizes, and we are also earning higher average fees per transaction. In addition, restructuring activity continue to be a solid contributor.
The fee part of this is interesting. Achieving pricing power in this environment is a big accomplishment. Query whether that relates more to M&A and less so to restructuring given the relative dearth of bankruptcy deal flow. Regardless, here’s what the stock did on Tuesday, a day the S&P 500 otherwise declined 1.34% and the Dow was down 424 points:
When asked about restructuring, specifically, this is what Mr. Moelis had to say:
Well, never expect things to only get better, but it's been - look, it's been a low default environment for a long time. And I think some of the peers and competitors have kind of - who were edging into restructuring might have edged out a bit; we're not. We think we have the leading restructuring group on the Street. They've been together for years and years and years, and now the way we integrate them, the amount of spread we can get using the 120 on these to really make sure that they are talking to companies that are having issues. And those issues could be opportunities, too. It's almost - it crosses over with liability management. It might stay to be a 1% or 2% default rate for a while . You can never tell. But there's a large amount of paper out there. So even at 1% or 2%, you can stay busy if you have a market-leading restructuring group which we do. Look, it could get worse. I guess nobody could default, but I think between 1% and 0% defaults and 1% and 5% defaults, I would doubt we hit 5% before we hit 0%. So, I'm happy we held the team together, we've added to it, we've integrated it, it continues to be a solid part of our business, and I think it has a lot more upside than downside.
Ok, so this must be a misstatement. He must have meant that he doubts that we reach 0% rather than 5%. And so: A. Lot. More. Upside. In late 2019? Early 2020? Who has edged out? Will others between now and then? The analysts didn’t ask those questions.
3. Q1 '18 Preliminary Review (Part 4: Case Administration Agents)
In parts one (Legal), two (Investment Bankers - Members’ only) and three (Financial Advisors - Members’ only) of our ‘18 “Preliminary Review,” we noted that Q1 was dominated by Kirkland & Ellis LLP, Weil Gotshal & Manges LLP, Evercore, PJT Partners, and Alvarez & Marsal North America LLC. As we looked at the statistics, however, it has become abundantly clear that the success shared by those firms in gobbling up large company-side cases is nothing compared to another industry player that, we’ve come to realize, is the epitome of company-side domination. Introducing Prime Clerk LLC.
Now this is an impressive case roster: Cenveo Inc., iHeartMedia Inc., Fieldwood Energy LLC, Claire’s Stores Inc., Southeastern Grocers, FirstEnergy Solutions. And that is just in Q1. Last year the firm was involved in Toys R Us Inc., Takata Inc., Puerto Rico, Seadrill Ltd., Avaya Inc., The Gymboree Corporation and Payless Holdings LLC to name just a small sampling. With the exception of Puerto Rico and First Energy, Weil or Kirkland is at the helm for every single one of the above cases. In other words, as much as Kirkland and Weil have dominated debtor market share, Prime Clerk has dominated Kirkland and Weil. And that is apparently not just a Q1 phenomenon. Already in Q2, Kirkland and Prime Clerk have been working together on EV Energy and Nine West Holding. We’re too time-constrained to dig back into 2017 or before, but something tells us that we’d start seeing a longer-dated pattern here. No wonder The Carlyle Group sank its claws into this case administrator: it is a practical monopoly of a duopoly.
4. WeWork Taps the Capital Markets
And the capital markets are being asked to finance this “state of consciousness” pioneer-of-new-valuation-methodologies company to the tune of $500 million (unsecured at approximately 8%). Yield baby yield!! This sums it up pretty well:
WeWork, a company that sells puts on office real estate to mostly cash flow negative companies, with a side gig on wave pools, is offering $500MM in unsecured junk bonds. The unicorn bond market is alive and well. pic.twitter.com/N1HD4xWwdLApril 24, 2018
Some gems from WeWork's bond offering:
1. WeWork doesn't design offices - it "programs space"
2. "Micro-brewed coffee" is important enough to be mentioned in the second paragraph of the company's product description
3. "Space as a service" is mentioned 253 times #WeWork
WeWork : Huge barriers to entry
Who could sub lease real estate
and offer free gummy bears. 😂😂
Anyway, there’s more to it than that: the Financial Times does a preliminary dive into the company’s financials. Some things of note:
Capital Structure. The company has an untapped credit facility and various letter of credit with total availability of $1.15 billion of liquidity. Pre-money, it has approximately $2 billion of cash on hand. Post-money, $2.5 billion.
Reach. The company has 234 locations in 73 cities in 22 countries. 220k memberships.
Revenue. Total revenue in 2017 was $883 million with run rate revenue at $1-1.5 billion. The FT calculated EBITDA at negative $769 million. Or as Fitch put it:
As a company in a sustained growth mode, WeWork is not profitable on a combined basis, as significant growth operating expenses more than offset existing property cash flows, resulting in strongly negative FCF.
Hahaha. “Strongly negative FCF.” This is like Demi Moore “strenuously object[ing]” in A Few Good Men. Strenuously objectionable negative FCF here!
Revenue Makeup. Membership revenue increased nearly 100% from 2016 to 2017. An increasing percentage of the company’s revenues are coming from enterprise tenants such as IBM, Facebook and others — which makes the company less dependent on short-term “puts” by month-to-month tenants with easy outs. Still, it is very much dependent on short term agreements that could theoretically go *poof* within any given 30-day period. Also, the company had been filling desks by drawing away tenants from rivals by offering a free year as recently as Q4 last year. We suppose we’ll see how sticky those tenants are if the company is called upon to update its desk occupancy numbers. Given this information, the 81% occupancy rate is probably a bit inflated.
Structure. Each location is set up as its own special purpose entity. The leases are secured by letters of credit or limited corporate guarantees covering approximately 6-12 months on a 15 year leasehold term. This means of roughly $18 billion in lease obligations, the parent is on the hook for roughly 10% or $1.9 billion. Bloomberg writes,
Investors can also take comfort from the fact that each of WeWork’s locations is housed within a separate subsidiary and isn’t directly leased by the parent company. While landlords are given guarantees or credit letters from the parent, these usually last for just six to 12 months on an average 15-year lease, according to the bond documents. That should give WeWork more flexibility to close locations if times get tough in a downturn, mitigating the risk of signing long-term leases while renting space to members on short term contracts.
“More flexibility,” however, doesn’t meant they’re off the hook. $1.9 billion is still a large number.
We’ll (likely) have more on this on Sunday but given that the (Fitch and S&P rated junk) bonds may place today (and we’d venture to guess that they’ll be upsized or priced downward due to demand), we wanted to put this on your radar now. Also, recall how we mentioned that the stock market capitulated yesterday? Well:
In retrospect, we should've known that WeWork issuing bonds would anger the market gods.April 24, 2018
We understand that you are hungry for a$$-kicking resources on the topics of restructuring, tech, finance, and disruption. We’re compiling a "reading list," of sorts for your benefit. You can find it here. We’ve added “When the Wolves Bite: Two Billionaires, One Company, and an Epic Wall Street Battle” by Scott Wapner because we’re super stoked to read it.
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