For some time, the BDC Credit Reporter has been promising to undertake credit post-mortems of under-performing BDC investments that reach the end of the line, and are removed from active status. That removal can be because of a successful resolution where all invested capital is returned or any number of scenarios where some sort of realized loss is incurred. Expect more of the latter than the former. The goal of looking back is to ascertain how an investment played out and what we can learn in hindsight about the risks taken and what the outcome tells us about the underwriting of the BDCs involved. As always, information is patchy and we will have to make some assumptions to get to any conclusions. Nonetheless, we believe this is a valid undertaking which should be instructive, both about whatever individual investment is involved and as a window into the broader leveraged debt investment process.

Our inaugural post is about Hollander Sleeping Products, a bedding manufacturer, which first appeared on the books of PennantPark Floating Rate (PFLT) and sister firm PennantPark Investment (PNNT) in late 2014 and was originally consisted of $35.5mn in first lien term debt due in 2020. The debt was priced at LIBOR + 8.0% and was a syndication. The debt was part of the leveraged buy-out of the company by Sentinel Partners. The type of borrower, the pricing, the terms and the purpose were in line with both BDCs stated target market. The external manager does not seem to have originated or “controlled” the loan.

That initial loan performed very well and was valued at or close to par throughout its entire tenure, which ended with its pre-payment in the middle of 2017. At that time, the company acquired Pacific Coast Feather and raised a new Term Loan – also first lien – with a 2023 maturity which, presumably, also financed the acquisition. The pricing remained the same: LIBOR + 8.0%.

“The merger makes Hollander the single-largest supplier in the U.S. in the home textiles industry,” said Jennifer Marks, editor-in-chief of industry publication, Home & Textiles Today. She said Hollander already was the single-largest supplier in the nation of filled utility bedding”.

From a valuation standpoint, the new loan performed well all the way up to IVQ 2018 when a (3%) discount was applied by the BDCs, more or less in line with the trading value of the debt at the time. However, by the IQ 2019 the debt was on non-accrual and by May 19, 2019 Hollander filed for Chapter 11.

As of March 2019 the debt was valued at a discount of only (13%) and as of June – which the last quarter on the books – the discount was (53%). At the time, an analyst inquired as to why the valuation could remain so high on a non accruing debt and the BDC manager pointed to the valuation firm who came up with the number, probably linked to the “trading” price of the debt.

The company blamed higher raw material costs and the expense of integrating Pacific Coast for its failure. The initial plan involved new DIP financing from ABL lender Wells Fargo and its existing term lenders. PNNT and PFLT ponied up $3.3mn of extra debt for a total of $34mn. The initial idea was to undertake a partial debt for equity swap.

However, by September management switched course and returned to court to request that the plan be changed to a $102mn asset sale to the only remaining would-be strategic buyer:

“A revised plan with a “toggle” feature to allow switching to an asset sale was put to a vote by the impaired creditors and received approval from the holders of all of the company’s $173.9 million in term loan debt and the holders of more than 95% of its $38.5 million in unsecured debt, it said.

Hollander noted that additional changes to the plan include that the providers of the company’s $90 million in debtor-in-possession funding have agreed to accept less than full repayment and to cede repayment priority to Hollander’s prepetition term loan creditors, as well as the establishment of a $1 million wind-down reserve fund.”

As a result of the sale – according to PennantPark – its Hollander investment “was written down completely “. Exactly what that means is not clear as neither BDC calls out by company realized losses. We know that Hollander is no longer carried as an investment as of the September 2019 results and that the PNNT Realized Loss for the quarter was exactly equal to the investment at cost in the 2023 Term Loan. Maybe the DIP financing was repaid in full ?

PennantPark claims it favored proceeding with the debt for equity swap but was out voted by other lenders not willing to move forward in that direction. However, as the quote above shows in the final plan “all” the company’s term debt creditors voted for the asset sale.

From PennantPark’s standpoint the lesson learned from its substantial ($30mn) or so loss is the risk involved in sponsor-led company “roll-ups” and insufficient oversight by the PE group. Here is what was said on the PFLT CC: “And with Hollander, they were just doing too many acquisitions too quickly. They didn’t have enough kind of oversight of the company. And the last acquisition didn’t work. So moving too quickly“.

From the BDC Credit Reporter’s standpoint there are 3 lessons here:

1. Investments can go from hero to zero in a very short period (i.e. from performing to under-performing or non-performing in this case). We doubt that Hollander’s business performance deteriorated so quickly, suggesting that there can be a lag between when bad things begin to happen (higher costs in this case) and its reflection in the valuations despite all those experts re-valuing positions every 3 months. Maybe there was undue reliance on the “market price” of the debt rather than an evaluation of the enterprise value of the firm.
2. As is often the case, a “First Lien” or “Senior Secured” nomenclature tells investors very little about the prospects of capital recovery – in this situation nil – when a default/bankruptcy occur.
3. BDC lenders – if PennantPark is a fair example – are loath to offer much in the way of financial details or color about “failed” investments. Just identifying how much realized losses come to is difficult. In terms of discussion, the manager offered on PFLT’s Conference Call only 3 sentences in their IIIQ 2019 conference call on the subject. Yet, the realized loss incurred for the quarter was roughly equal to the BDC’s entire Net Investment Income, on which much more time was spent parsing the numbers. Most of what we did learn about Hollander – slightly more substantively – came in response to analyst questions. It’s understandable that managers don’t want to linger over credits gone wrong but – in our opinion – it’s a critical element for investors to evaluate how much of performance is “idiosyncratic” and how much not.