Big Picture

Another BDC debt financed retailer files Chapter 11. Once again, the failed company’s lenders come to the rescue to step into the shoes of the prior owners and seek to reposition the business with a new balance sheet. Back in the day when banks were the principal lenders to companies, a work-out unit of the institution would be called in when a borrower stumbled in this way and – most of the time – the goal was to stabilize and divest the debt as soon as practical. Distressed debt investment groups would step up to buy into the company, seeking to buy low; turn around the business and sell high. (We were that “distressed financial buyer” back in the day, so we discuss the subject with some first hand knowledge). The bank in question would move on to other transactions, and regulators would stop hounding them. 

New In Town

Now, with asset managers owning public and private funds and multiple other types of leveraged lenders being the principal financiers of companies, the whole attitude and process towards failed businesses has changed. More often than not the existing lenders wave away the under-employed distressed debt players  – usually distinct units within some other vast asset management organization – and roll up their sleeves to take over and turn around the business. The easiest change to make is the structure of the very capital advanced by the lenders themselves, and that’s the principal tool used to gain control of the company. Debt is extended or written off or exchanged in return for control. That’s often not enough and the would-be new owners have to offer Debtor-In-Possession facilities to keep the doors open as these bankruptcies tend to occur after management and the incumbent owner have exhausted all resources in an attempt to stay afloat, which seems appropriate.

More, More, More

Most of the time even that new capital is not enough and additional debt or equity is required and the only group with all the facts and able to move fast enough are the existing lenders-soon-to-be-owners. Often a new CEO is brought in; business strategies are tweaked or drastically changed. A restructuring plan is typically agreed even before the bankruptcy is announced, which saves a great deal of money because being under court protection – like having a bed in a hospital – is a very expensive undertaking and the shorter time spent there the better. Once a company exits with its new capital structure/CEO/strategy combo,  years may pass till the parties involved can determine if all their efforts have been worthwhile or in vain. For a lender who started out making a 5 year loan, that is usually expected to last 3 years, this might mean a 7-10 year time horizon before Mission Accomplished or a disappointing  final write-down occurs. Moreover, the economics of the investment change drastically from receiving periodic yield to potentially going years till an equity stake is finally sold in an uncertain future. 

Illustration

We mention all this as a preamble to this article about Bluestem Brands, because this may serve as an illustration of what is happening to the company and its current lenders. More importantly, this story is part of a much bigger trend that has been going on since the banks departed the scene – which began even before the Great Recession – and which is likely to become much more prevalent in the quarters ahead if the economy tanks and bankruptcies such as these become much more common. Very roughly, we wouldn’t be surprised – based on historical data – to see bankruptcies and restructurings increase five fold over the next year if the worse happens in the economy. [Ironically, lenders who always claim that they try to steer away from “cyclical businesses” are themselves the most cyclical of all). 

Jury Out

It is not clear that just because you can do something – in this case take over a bankrupt borrower and become its owner – that’s an appropriate use of your capital. Even in the midst of the recent never expanding economic expansion there are multiple stories of lenders failing to achieve the desired results and ending up in “Chapter Twenty Two” and – nine times out of ten – in liquidation, with very little to show at the end.  Think Charlotte Russe,; Payless Shoes; Charming Charlie, etc. More difficult to assess are the many companies which have not yet reached a final destination and equity stakes owned by BDCs might or might not be worth what the parties are hoping they will. There is a very long list of such companies in leveraged investing, including many on the books of BDCs from Prospect Capital (PSEC) to Apollo Investment AINV) to PennantPark Investment (PNNT)  and even at otherwise successful BDCs like Gladstone Investment (GAIN). BDC shareholders are – indirectly – paying management fees on transactions that began as loans and have become equity investments of questionable ultimate value and with no terminal date scheduled. Equity – or even debt is you’re both lender AND owner – is “permanent capital”. There are BDC investments out there getting very long in the tooth – a decade or more. 

Sooner Rather Than Later

We expect that the number of these BDC “lender to owner” investments will grow substantially and, for each BDC involved,  materially impact how income plays out between income producing and non-income producing assets and over a much different time frame than originally anticipated and with different compensation and other operating costs than first envisaged. (Overseeing a business takes a lender requiring different staff and costs – all those Board meetings ! –  than clipping a quarterly interest coupon when all is well). As a result, BDC investors will need to assess how the addition of a number of this type of portfolio company will impact long term returns. Maybe we’ll see in a few years a series of equity sales and much champagne flowing as these restructured investments are sold to new buyers. Or we’ll quietly witness – to the degree BDCs fess up to the situations – delayed write-offs of unsuccessful turnarounds. BDC shareholders – in fact all investors in private credit – have a right to ask the managers of the funds involved what track record; human resources and strategic approach (long term holders ? stabilize and sell ? etc) they bring to these situations. Also, where does the BDC involved sit in terms of making decisions in the New World Order ? Just along for the ride or essentially serving as the new PE Managing Member ? 

Crickets

Shareholders should also be asking – but are unlikely to be warmly received by the BDC involved – a greater level of disclosure about these type of longer than initially expected investments. Once a restructuring is completed and the company emerges from Chapter 11, a veil  often falls over the business even though the BDCs – as owners – have much more information than ever before about finances, strategy and outlook.  If BDC shareholders are going to be – effectively speaking – asked to exercise patience and trust the manager “knows what it’s doing” rather than kicking the can down the road using shareholders capital, above average disclosures in filings and on conference calls is called for. The opposite has been happening to date, although the degree of opacity varies by BDC. For our part, we are going to begin pro-actively  keeping track in our database – and in future articles – how this type of debt-to-own investment is performing for every BDC with material exposure (which is already a very large number of players) and assess for our readers what progress is being made. Unfortunately, the required disclosures about “control” investments in BDC filings are laughably inadequate as information provided – typically buried deep in the filings and rarely discussed in conference calls – can be more misleading than helpful.

Funny World

In closing, we’d say that an ironic development is occurring that could materially change the nature of BDC investing. Huge asset asset managers who made their money and reputation in private equity and then set up credit arms to get into leveraged lending may end up with portfolios heavily weighted with “control” equity investments in an almost full circle. If that is good for BDC shareholders – or at least better than the old bank model – is something we will not be drawn on. Instead, we are just going to track performance over time and – in several years time ! – let you know what the record shows.  

Bluestem Brands: Drops Rating and Downgraded

After many quarters of balancing on the brink, Bluestem Brands Inc. has filed for Chapter 11. In a press release, the retailer indicated its commitment to remaining in business through the bankruptcy process, and the arrangement of a $125mn DIP financing by a “syndicate of lenders”. The “syndicate” is also serving as a “stalking horse bidder” for the company’s assets, and seeks to de-leverage and restructure the company’s balance sheet.

Who are the members of the syndicate ? Not disclosed. What might the assets be valued at ? Not mentioned ? How much debt might be wiped from the balance sheet ? Still to be determined. Nonetheless, this seems to be a classic debt-for-equity swap where the lenders become part, majority or the exclusive owners of the new Bluestem Brands. Sometimes that works, and sometimes not.

We’ve been writing about Bluestem Brands for a very long time, both in the BDC Credit Reporter and in our database of all under performing BDC companies that we maintain. Barely a week ago we wrote to ourselves the following summation of our views:”3/4/2020: We worry that Bluestem might be about to meet its moment of reckoning in 2020 with the need to repay its publicly traded Term Loan in November 2020 and its modest liquidity above the mandated level at the end of the IIQ 2019. Sales and EBITDA trends are either anemic or negative. The debt is already discounted by nearly a quarter. As a result, we’ve added the company to the 2020 At Risk Of Non Accrual  list.”

Now that’s happened we’ll be interested to see what the 4 BDCs with $28.2mn of exposure at cost  – Main Street (MAIN); Capitala Finance (CPTA); Monroe Capital (MRCC) and non-listed HMS Income – will be doing. We imagine they are committed to a portion of the DIP financing and are likely to end up as owners, and may also be committing more junior capital. As mentioned above, we don’t know how much historical debt will be forgiven. So any sort of valuation is hard , but Advantage Data shows the 2020 Term debt in which all the BDCs are invested trading at a (29%) discount; just slightly worse than the recently announced IVQ 2019 (25%) discount announced by the three public BDCs. That suggests, but does not guarantee, the eventual realized loss to be taken might be over ($8mn). In an earlier article, though, we’d been estimating ($15mn). More immediately, income forgone will be about ($1.4mn) annually, mostly absorbed (4/5ths) by sister BDCs: MAIN and HMS Income.

We will report back as we learn more about how this bankruptcy will play out, and what individual BDC exposures to old and new capital (if any) will look like.

@2020 BDC Credit Reporter