A meme stock isn't characterized by financial fundamentals but rather by the hype generated by online retail investor communities. It goes without saying that their valuations are not grounded in traditional financial logic. The influence of online communities (such as Reddit) is what drives prices.

Online communities target specific companies and coordinate their purchases to drive up prices.

Factors that have contributed to the rise of meme stocks include:

• Commission-free trading platforms like Robinhood

• Mobile trading accessibility

• 2020 stimulus checks

If you follow markets at all, none of what we’ve said so far comes as a surprise.

Here’s the thing. ZIRP is dead. Stimmy checks are long gone.

Meme stock traders are still around, pouncing on the flailing bodies of distressed companies in their weakest moments.

Subreddits, particularly WallStreetBets, have played a massive role in this trend. Reddit has a platform of user-generated content, and its communities (subreddits) focus on various topics, including investing. WallStreetBets, r/stocks, and r/investing are prominent investment-focused subreddits.

StockTwits is another platform where investors share ideas. The majority of these platforms' users are young males with some college education and modest investment funds.

Historical Parallels

Meme stocks have similarities with the stock pools of the 20th century, where the price of securities was manipulated for insiders' benefit.

Past attempts to manipulate stock prices include efforts to "corner" the market, where an investor tries to gain so much control that they can influence prices. Notable examples include Jay Gould and Commodore Vanderbilt's attempts in the railroad stocks and the Hunt brothers' attempt with the silver market.

Bankrupt Companies

The most entertaining (and infuriating for some) aspect of the meme stock phenomenon is that meme traders take aim at distressed or even bankrupt companies. WeWork, having already spent years being the butt of jokes among online finance communities, recently joined in this trend.

WeWork stock soared over 160% after announcing that the company may not be able to survive. WeWork's stock is down 97% since its 2021 SPAC deal, with its market cap falling from $9 billion to $300 million. The company, which hasn't turned a profit and has lost $16.4 billion since 2018, faces challenges from the growing work-from-home trend and issues in the commercial real estate sector.

The trend of boosting stock prices for financially unstable companies began in early 2021 with GameStop and later affected AMC Entertainment. This price inflation, primarily fueled by retail traders, can offer struggling companies a chance to raise funds by selling shares at inflated prices.

Why do meme traders go after dying companies?

Let’s look at a few examples

Tupperware

In May 2023, Tupperware hired Moelis & Co. for “strategic advice” (translation: a restructuring). This came after the company delayed its 2022 annual report due to accounting misstatements in prior years. Tupperware was facing a liquidity crunch and needed new financing.

Perhaps feeling encouraged by the AMC stock rally, meme traders sought out their next target. Tupperware's stock rose nearly 300% in the last month, supported in part by reaching a debt restructuring deal. The stock is one of the most popular discussions on Stocktwit. As of July 15, 27% of Tupperware's public float was sold short and the stock was trading at $0.65.

Bed, Bath, & Beyond

Bed, Bath & Beyond Inc shares experienced a significant rise in trading on January 9, 2023 spurred by retail investor speculation that the underperforming home goods retailer could be a likely buyout candidate. The stock saw an impressive 35% increase to $1.77, marking its most significant single-day percentage boost since Aug. 8. By mid-day, trading volumes reached $114 million, almost equivalent to the firm's total market cap of $157 million, based on Refinitiv's data.

Online discussions about a potential merger and acquisition deal for the company have been rampant on platforms like Reddit, mirroring the "meme stock" trend of 2020. This trend witnessed stocks of distressed firms, like GameStop Corp (GME.N) and AMC Entertainment Holdings (AMC.N), skyrocketing due to heightened attention on platforms such as WallStreetBets.

The value of Bed, Bath & Beyond's stock plummeted almost 50% the previous week after the company hinted at potential insolvency and the possibility of seeking bankruptcy. Furthermore, a Reuters report indicated that the company might pursue bankruptcy protection soon.

For years, Bed, Bath & Beyond has grappled with dwindling sales, facing stiff competition from giants like Amazon (AMZN.O) and other competitors. Common criticisms from investors include the retailer's cluttered store layouts and an excessive dependence on discount coupons. In 2022 alone, the company's shares dropped by 83%.

Last week's company filing revealed an anticipated net loss of $385.8 million for the fiscal quarter ending in November, which includes $100 million in impairment charges. Currently, out of 13 analysts tracking the company, three suggest "hold," eight advise "sell," and two have given a "strong sell" rating. The average stock price target is now $2, reduced from $3 the previous month.

Yellow

Shares of Yellow Corp, a U.S. trucking company, saw a dramatic increase, surging over 67% after its value more than doubled in a previous session. The Teamsters Union revealed that Yellow had stopped operations and was declaring bankruptcy. Despite its financial struggles, the company's stock became highly popular among retail traders.

Why Troubled Companies Become Targets

There are a number of factors at play that make distressed companies particularly good targets for meme stocks.

• Short Squeezes: Many struggling companies have significant short interest. Short sellers are betting that the stock price will decrease. Meme stock traders mobilize these companies to initiate a short squeeze. If they buy in large enough quantities, the stock price goes up, and short sellers may be forced to buy shares to cover their positions, driving the price up even further.

• Social Media and FOMO: Platforms like Reddit, Twitter, and Discord allow retail investors to rally behind a particular stock, amplifying its popularity. Fear of missing out (FOMO) can lead to rapid buy-ins from a large number of traders, pushing the price up.

• Rebellion Against Institutions: Part of the appeal of investing in struggling companies is the David vs. Goliath narrative of small retail investors vs. large institutional investors or hedge funds. Many meme stock traders see themselves as fighting against a system that is rigged in favor of big players. That doesn’t mean institutions aren’t participating in or perpetuating trades surrounding meme stocks.

• Speculation Over Fundamental Analysis: Traditional stock investing emphasizes a company's fundamentals, such as its financial health, profitability, and growth potential. Meme stock trading prioritizes fuels momentum and sentiment over these fundamentals.

• Visibility: As a company nears bankruptcy, it often gains more media attention. This increased visibility can make the stock more appealing to retail traders looking for opportunities. Meme stocks also tend to be companies that have recognizable brands among consumers (although meme traders appear to be evolving).

• Gamification: Modern trading apps, with their easy-to-use interfaces and features, have gamified stock trading, making it feel more like a strategy game for many users. This has further encouraged speculative trading.

• Potential for High Returns: The volatility associated with these stocks means there's potential for massive gains in a short amount of time. However, there's also a significant risk of substantial losses.

This is normally the part where we would tell you where to look for the next meme stock. However, we have not spent enough time in these online communities to have a pulse on what meme stock is up next. Were we interested in becoming meme stock aficionados, we would maintain a list of companies approaching distress, rank them in order of visibility to retail (presence in the consumer market), then monitor discussions on online communities such as Reddit, Stocktwit, and Twitter based on this watchlist.

Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

The Sackler family owns Purdue Pharma, a now bankrupt company whose main product is Oxycontin.

Oxycontin is an addictive pain killer that was released for sale in 1996. It made the Sacklers billionaires, with their wealth estimated at a whopping $11 billion.

Lawsuits allege that Purdue Pharma misled doctors about how addictive OxyContin was, causing many patients to become hooked on opioids. Many of those patients later turned to illegal drugs like heroin, sometimes laced with lethal drug fentanyl.

Bankruptcy courts across the U.S. have been divided on whether or not legal protections extend to the family.

On May 30, 2023, the United States Court of Appeals for the Second Circuit held that bankruptcy courts have the authority to approve plans with non-consensual releases of direct third-party claims against a non-debtor, which would allow for the Sacklers to walk away without any risk of civil lawsuits pertaining to their handling of OxyContin.

On August 10, 2023, the U.S. Supreme Court decided to hear an appeal about the legality of the settlement shielding the Sackler family. The bankruptcy proceedings for Purdue have been paused and a hearing is set for December 2023.

Today’s post dives into the spotted history of the Sacklers and Purdue Pharma and digs into the bankruptcy case.

The Sacklers

Harvard. Oxford. Yale. NYU. The Guggenheim Museum. The Met. These are just a small handful of the dozens of institutions that currently or at one time held the Sackler family name as a result of millions of dollars in donations. Individuals of the billionaire variety often attempt to tackle their own mortality by extending their legacy through institutions that will live on well beyond them.

Arthur Sackler got his start as an entrepreneur through advertising and copywriting in 1942. His marketing of tranquilizers like Valium and Librium in the 1960s made him wealthy. His ads promoted the use of Valium for anything and everything, ranging from stressed out students to people with no psychiatric symptoms whatsoever.

Over time, he came to the realization that pharmaceutical marketing should extend not just to the patient, but also to the physician.

In 1952, Mortimer, Raymond, and Arthur Sackler acquired a small medicine company called Purdue Frederick, the company which is now known as Purdue Pharma.

The histories of the Sacklers and Purdue are littered with examples of buying favor with regulators, respected doctors, and likely other influential decision makers at all levels. For example, the FDA examiner who oversaw the approval process for OxyContin left the FDA shortly after and ended up employed at Purdue less than two years later. What a coincidence!

Before OxyContin, Purdue’s best seller was a morphine pill painkiller called “MS Contin". As the patent for that drug expired in the late 80s, Purdue began searching for a replacement.

In 1995, Purdue Pharma introduced OxyContin as a palliative for chronic pain. Under a strategy initiated by Richard Sackler (son of Raymond Sackler) and earlier pioneered by Arthur Sackler, Purdue Pharma aggressively promoted OxyContin to doctors, offering them incentives such as free trips to pain-management seminars and paid speaking opportunities.

OxyContin was advertised as providing prolonged pain control with a lower potential for abuse due to its time-release properties, despite lacking scientific evidence for such claims. The drug's addictive nature was not new, as the addictive quality of opiates has been known for millennia.

It just so happened that around the time that OxyContin was launched, there was growing literature from highly regarded doctors (on the take from Purdue, no doubt) about the stigmas around opioid drugs being addictive, and that concerns about opioid addiction were overstated.

Purdue played a key role in the liberalization of the use of opioids in the treatment of pain, particularly for chronic non–cancer-related pain (a larger market than cancer-related pain).

Between 1997 and 1999, Purdue Pharma was aware of the drug's misuse, with evidence like the drug being snorted or stolen and certain doctors illicitly selling prescriptions. Over a hundred internal memos during this period mentioned terms like "street value," "crush," and "snort."

By 2000, OxyContin abuse became more apparent. A program sponsored by Purdue Pharma highlighted OxyContin as one of the most abused pain medications. By 2012, a study linked Purdue's OxyContin marketing to the U.S.'s heroin epidemic, stating that many heroin addicts started by abusing OxyContin.

In 2003, the Drug Enforcement Administration claimed that Purdue's aggressive marketing played a significant role in exacerbating OxyContin's widespread abuse.

Between 1995 and 2001, OxyContin generated $2.8 billion in revenue for Purdue Pharma. By 2017, this had risen to $35 billion. The owning family of Purdue Pharma, the Sacklers, have been reported to have a net worth of $11 billion, although some states claim it's even higher. OxyContin represents 80% of Purdue’s business.

According to the Committee of Oversight and Reform, the Sackler family’s assets as of April 2021 were as follows:

• The Sackler family’s total net assets equal approximately $11 billion.

• The Sackler family has more than $950 million in cash.

• The Sackler family holds more than $2.9 billion in marketable securities, hedge funds, and brokerage accounts.

• The Sackler family owns more than an estimated $1 billion in international drug companies.

• The Sackler family owns more than $1 billion in real estate.

• The Sackler family holds more than $1 billion in private equity investments.

• The Sackler family owns more than $250 million in art, jewelry, and other collectibles.

At that level, it’s difficult to estimate what the family’s true net worth is. It’s safe to assume that the Sacklers are highly incentivized to understate the value of their assets.

Understanding OxyContin

Oxytocin is commonly recognized as the hormone related to social bonds, particularly in contexts like love and child-rearing. Its connection to such behaviors has led to its colloquial naming as the “cuddle” or “love” hormone. This is because oxytocin is released during intimate activities.

While oxytocin does play a role in promoting attachment, empathy, and bonding, it also has a darker side. According to Lily Brown, PhD, from the University of Pennsylvania, oxytocin can lead to feelings of jealousy, suspicion, and even the creation of "in" groups and "out" groups. In certain situations, the presence of an individual not deemed as part of one's "tribe" can amplify negative emotions toward them when oxytocin levels are high. Essentially, oxytocin's effects seem to be influenced by the context in which it is activated.

In response to the drug's negative impact, protests and initiatives arose, including artist Nan Goldin's organization P.A.I.N., which aimed to deter cultural institutions from accepting Sackler Family donations.

Not looking to let an opportunity to profit go to waste, in 2018, Purdue Pharma patented a new form of buprenorphine to treat opioid addiction, including addiction to OxyContin. How convenient that such a market opportunity exists!

Robert C. Froemke, PhD, a neuroscientist from New York University, explains that oxytocin should not be oversimplified as merely a "trust hormone" or "love drug". Instead, its function might be likened to a volume dial, amplifying whatever the brain is already processing, rather than universally promoting positive feelings.

Regarding its mechanism in the brain, oxytocin originates from the hypothalamus and is then released into the bloodstream by the pituitary gland. Depending on its function, it can be directed towards the spinal cord or various parts of the brain. Once released under appropriate conditions, oxytocin can manage our emotional responses, influence pro-social behaviors, and even regulate feelings of trust and empathy.

Bankruptcy Timeline

In September 2019, Purdue Pharma filed for bankruptcy after a tentative settlement related to lawsuits regarding the opioid epidemic.

Many states rejected the initial proposed settlement, accusing the Sackler family of hiding funds. The inclination to settle varied with state political affiliations. States aimed to hold the Sackler family accountable, despite Purdue's bankruptcy.

An audit in December 2019 showed the Sacklers withdrew $10.7 billion from Purdue after legal issues began.

The Sackler family tried to secure legal protection against lawsuits tied to the opioid crisis. In response, the U.S. introduced the SACKLER Act to prevent those not in bankruptcy from being shielded from certain lawsuits.

In September 2021, a $4.5 billion plan was approved, converting Purdue Pharma into a public benefit corporation to address the opioid crisis. The plan would protect the Sacklers from civil lawsuits. However, in December 2021, this decision was overturned.

In March 2022, a new settlement was approved: the Sacklers would pay $5.5 to $6 billion to a trust addressing the opioid crisis, shielding them from personal civil liability but not criminal liability.

In May 2022, a U.S. appeals court debated the legality of shielding the Sacklers from debts, despite them not filing for bankruptcy. There were differing opinions on whether this was permissible under U.S. bankruptcy law.

In May 2023, the 2nd U.S. Circuit Court of Appeals in New York approved the $6 billion settlement, making the Sackler family relinquish Purdue ownership and using all profits to combat opioid addiction. This ruling also provided legal protection to the Sacklers, even though they didn't file for bankruptcy.

On August 10, 2023, the U.S. Supreme Court decided to hear an appeal about the legality of the settlement shielding the Sackler family. The bankruptcy proceedings for Purdue were paused, with a hearing set for December 2023.

Third-party Releases

Estimates state nearly $11 billion was taken out of Purdue and dispersed through trusts and shell companies around the world to the benefit of the Sackler family in the eleven years leading up to the bankruptcy. As part of the settlement, members of the family would contribute up to $6 billion over ten years, subject to the condition that they receive third party releases.

“The plan’s release “absolutely, unconditionally, irrevocably, fully, finally, forever[,] and permanently release[s]” the Sacklers from every conceivable type of opioid-related civil claim -- even claims based on fraud and other forms of willful misconduct.”

Here’s some inside baseball: releases are quite common in bankruptcies. The debtor’s management/board will essentially threaten to hold the plan hostage unless releases are granted. Creditors, who are often funds and other commercial entities, want value to be distributed so they can move on. In the end, there is some back and forth, perhaps a few arguments, and creditors will try to extract some additional value in exchange for releases.

Most circuit courts allow these releases under certain circumstances, but there is ambiguity as to whether these non-consensual third-party releases are permitted by the Bankruptcy Code.

Note that these are releases from civil liability. If the Sacklers are released from civil liability, people or entities affected by the opioid crisis (such as victims, states, or municipalities) would not be able to sue the Sackler family in civil court to recover damages. Essentially, this would protect the Sackler family's personal wealth from lawsuits seeking financial compensation.

The Sacklers could still face criminal liability. In a criminal case, charges are brought by the government (state or federal), and the outcome can involve penalties like fines, imprisonment, or other forms of punishment. If members of the Sackler family were found to have broken the law (for example, if they were found to have knowingly contributed to the opioid epidemic through illegal actions), they could still be prosecuted and, if convicted, face criminal penalties.

Putting our citizen’s hat on, the Sacklers are clearly responsible for perpetuating opioid addiction for over two decades. Walking away from this by forking over some capital and remaining billionaires (which is a direct result of the sale of OxyContin, representing 80% of their business) doesn’t quite sit right.

Per the plan, Purdue would transform into a “public benefit corporation” focused on addressing the opioid issue. The remaining funds of the estate would cover operational costs and then be allocated to different creditor funds. The majority of these allocations would be dedicated to addressing the opioid problem. Based on this allocation method, an individual affected by opioids, even those with severe damages, might get an amount ranging from $3,500 to $48,000. Some of these payments could be distributed over a decade.

The family will also allow their name to be removed from buildings and scholarships.

Beyond bankruptcy courts, this case is politically important. The Biden Administration has challenged the ruling that would provide legal protections to the Sacklers. While surely we would all like to see them held accountable for the deaths associated with the opioid crisis, the longer the bankruptcy goes on, the longer it takes for victims and their families to receive their settlement. There are over 135,000 personal injury filings.

The initial plan of reorganization was approved by the bankruptcy court back in September 2021. Since then, the chief issue has been whether the Sackler family should be shielded from civil lawsuits associated with OxyContin (along with some amendments around contributions from the Sacklers).

If we were to bet, we’d bet that the Supreme Court rejects these third-party releases. We’re likely to find out in early 2024!

Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

The $18 billion bankruptcy of Las Vegas-based Caesar’s Palace netted bankruptcy professionals over $500 million in aggregate.

Advisors in the FTX bankruptcy billed over $200 million from November 2022 through June 2023 and the process is ongoing.

Corporate bankruptcies are a lucrative business.

Here’s why.

When a company is gearing up for a bankruptcy, the company and creditor constituents will bring on:

• Lawyer(s)

• Investment banker

• Restructuring consultant

Each of these advisors fulfill an important role and are compensated differently. Restructuring bankers will typically receive a monthly retainer plus a success fee. A success fee could be a simple flat fee, a percentage of transaction value, a fee for financing, or even a fee resulting from specific outcomes such as the sale of certain assets.

Operational consultants will make a team available to their client which consists of a Managing Director, Director, and Associates/Analysts. The debtor’s consultant would put in place the Chief Restructuring Officer. Operational consultants are the “boots on the ground” in a restructuring, responsible for developing an in-depth understanding of a company’s cash flow profile. Unlike bankers, consultants often spend considerable time on-site with the company developing analyses such as a 13-week cash flow model. Operational consultants are compensated on an hourly basis.

Bankers are the transaction experts, advising on the capital structure, forms of consideration, and financing. Consultants are the operational experts, dealing with sales, costs, cash flow management, and turnaround planning. In some instances with high industry-specific complexity, technical consultants may be brought on in addition to a restructuring consultant.

Last but certainly not least, restructuring and insolvency lawyers provide legal expertise in bankruptcies. Lawyers are often the first to be hired as a company approaches the realm of distress.

These advisors comprise the bulk of the fee burn and are the key players driving a restructuring process.

To understand how fees can add up, let’s walk through the fees from the bankruptcy of Caesar’s Palace.

The biggest rake went to Kirkland & Ellis, the lawyers representing the debtor, who collected $77 million in fees. This amount doesn’t include the $16.5 million Kirkland earned advising Caesar’s operating company CEOC over the six month period prior to the bankruptcy filing. CEOC’s restructuring consultant AlixPartners pulled in over $45 million over the course of the bankruptcy case. The investment banker Millstein & Co. got the short end of the stick, making only $7 million! Heck, even KPMG pulled $10 million from their role as tax consultants. C’mon now.

Unless you work in the sector or have dealt with a bankrupt investment, you probably don’t know that the fees of the advisors to most of the constituents in a bankruptcy are also paid for by the company.

In other words, the lawyers, bankers, and consultants of the creditors are also paid by the estate (subject to court approval). In complex cases with multiple creditor classes, these fees add up fast.

Caesar’s emerged from bankruptcy in October 2017. The last schedule of payments to restructuring professionals is available through September 2017. By this point, bankruptcy professionals had drummed up over $500 million in fees, $42.5 million of which were incurred prior to the company filing for bankruptcy. The fee burn averaged ~$14 million per month during the bankruptcy.

Here’s a list that includes most of the firms that were retained:

Note that the list above is not exhaustive. In particular, it excludes the advisors of CEOC’s parent company Caesar’s Entertainment (Blackstone [PJT], Paul Weiss), Caesar’s Acquisition (Moelis, Skadden), and strategic advisors to CEC’s Board of Directors (Centerview, Reed Smith).

Lawyers were the big winners in this case. Lawyers and consultants are compensated hourly, whereas bankers get the bulk of their fee once a deal is closed. Cases that drag on tend to benefit law firms and consultants more than the bankers. Bankers are highly incentivized to bring constituents to an agreement so that a transaction can be consummated and they can get paid.

High professional fees are associated with:

1. Long, drawn out bankruptcies

2. Complex capital and organizational structures

3. Disagreements among constituents

Caesar’s was unique because it was a highly contentious bankruptcy case that highlighted the lengths to which private equity firms would go to recover value. The case is famous for pitting well-known investors against each other. The distressed investing space and private equity industries are a small world. The same funds come across each other on deals and investments repeatedly. On the advisor front, you’ll see the same handful of firms in every major corporate bankruptcy.

While the industry is extremely competitive and distressed situations are naturally adversarial, you may not want to totally screw over your counterparties so you can still do business with them in the future.

This sentiment went out the door after the Caesar’s Palace case when sponsors Apollo and TPG aggressively exploited loopholes in the debt documents to divert value away from creditors and protect the value of their own position.

The situation was (at the time) regarded as an extreme case of “violence” among institutional investors, even for the bankruptcy world. If you’re interested in learning more, there is plenty of literature and media coverage on this case. We came across this thread which provides an excellent synopsis.

Corporate bankruptcies are high stakes situations with tens of billions of dollars (and people’s careers) at stake. Caesar’s is one of the most prominent examples of the knife fighting that has become common in the distressed space over the years.

You now know how professional fees reach exorbitant amounts in bankruptcies.

The question that remains is why do people pay these professionals so much?

Here are the top 5 reasons why restructuring professionals are able to command high rates:

1. The Best of the Best: The amounts of money involved in large corporate bankruptcies are substantial. As a result, there's a lot at stake for all parties involved, and they're often willing to pay for top legal and financial talent to protect their interests. When you have hundreds of millions of dollars on the line, you want to hire the best.

2. The Price is the Price: Market rates for lawyers, accountants, and financial advisors who specialize in corporate bankruptcy are high. These rates reflect their expertise, experience, and the demand for their services. Kirkland & Ellis is one of the most expensive bankruptcy law firms you can hire, yet they continue to win mandate after mandate using their relationships and reputation to swing big deals.

3. Complexity of the Case: Large corporate Chapter 11 cases involve complex legal and financial issues that require specialized expertise. Large corporations often have a multitude of stakeholders, including various classes of creditors, shareholders, employees, and sometimes even regulatory bodies. Each group may have different interests and legal rights, and balancing these can be a complex and time-consuming process. Additional complexities ranging from collapsing business operations to dealing with tax implications can make cases more challenging. The more complex the case, the more hours professionals need to work, and the higher the fees.

4. Duration of the Case: Chapter 11 cases can take a long time to resolve, often years. During this time, professionals are continuously working on the case, which adds to the total cost.

5. Litigation and Disputes: If there are disputes among creditors or other parties, or if litigation is necessary, this can significantly increase the amount of professional work required, time in bankruptcy, and thus the fees.

Let’s be real. No constituent wants to hundreds of millions of dollars coming out of the estate and going to advisors. However, bankruptcies aren’t always a terrible outcome for everyone. If a group of hedge fund bought up junior bonds at 40 cents on the dollar and received 80 cents in recoveries, they’re not likely to care as much about a few million dollars to their banker because they probably made hundreds of millions!

On the flipside, if the situation at the company deteriorated over the course of the bankruptcy process and those same bonds were worth zero, you can bet there will be a lot more frustration over the fees. Advisors may be asked to lower fees or kick a few bucks back into the estate (don’t hold your breath).

You now have an insider perspective on why bankruptcies are so darn expensive. Stay tuned for the next one!

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Appendix

Final fees approved to pay the advisors of the official committees of CEOC

Unsecured Creditors Committee (“UCC”):

• Lawyer: Proskauer - $28.7 million

• Investment banker: Jefferies - $10.6 million

• Consultant: FTI Consulting - $12.5 million

• Gaming industry advisor: G.C Andersen - $1.8 million

Second Lien Noteholders:

• Lawyer: Jones Day - $25.1 million

• Investment banker: Houlihan Lokey - $21.5 million

• Consultant: Zolfo Cooper - $8.1 million

Another $32 million was billed by court-appointed examiner Winston & Strawn.

Legal and consulting fees for the first three months of the FTX bankruptcy

The fees above total $85.5 million for the first ~3 months of the FTX bankruptcy. As of June 28, 2023 the total amount has reached over $200 million.

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Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

We’ve specifically highlighted BlackRock, Apollo, KKR, Morgan Stanley and JP Morgan. Below you can read about where these firms agree on their outlooks, where they differ on their outlooks, followed by our detailed notes on the individual publications. Beyond the usefulness of getting perspectives from large institutions, we also like to read these predictions for entertainment purposes to observe who gets things wildly wrong.

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On to today’s article.

Overlaps:

1. Economic Downturn: All five firms agree on the likelihood of an economic downturn or recession. This consensus is largely driven by the tightening of monetary policy, inflationary pressures, and distress in the banking sector.

2. Inflation Concerns: Persistent high inflation is a mutual concern across all firms, with most expecting it to continue until at least 2024.

3. Non-Banking Financial Sources: There is a shared emphasis on the role of non-banking sources of funding, such as private credit and asset-backed finance. These are seen as significant in supporting firms amidst challenges in bank lending and public capital markets.

4. Investment Opportunities: Private equity, private credit, and real assets are considered favorable investment areas by most firms due to their lower volatility and inflation sensitivity (and because these firms are active in these areas). Distressed situations, take-privates, and carve-outs are also seen as potential investment opportunities.

5. Equity Market Views: All firms generally express caution about the equity market, advocating for a focus on high-quality, resilient stocks and companies with strong balance sheets. Regional diversification in equity allocations is also suggested.

Key Differences:

1. Market Predictions: While Apollo and JP Morgan predict a hard landing, BlackRock leans towards a soft landing. KKR has a neutral to negative view for the global economy while Morgan Stanley expects a slowdown and divergence.

2. Investment Strategies: The firms have different focuses in terms of investment strategies. KKR emphasizes investments in infrastructure and residential real estate. In contrast, Apollo and Morgan Stanley focus more on private credit and private equity. BlackRock underlines the importance of maintaining portfolio resilience through diversification, and JP Morgan highlights the benefits of investing in dividend-paying stocks and sectors like healthcare and utilities.

3. Regional Perspectives: Morgan Stanley suggests an offensive approach in Asia and defensive approaches in the U.S. and Europe, whereas JP Morgan suggests more allocation to Europe for diversification. KKR and BlackRock don't provide specific regional investment strategies.

4. Recovery Expectations: Morgan Stanley predicts a sluggish global economic recovery with significant regional differences. In contrast, JP Morgan sees the service sector as resilient despite manufacturing challenges and anticipates China's recovery to mirror other regions with service industry improvements.

5. Inflation Expectations: While most firms expect high inflation to persist, JP Morgan predicts a decrease in inflation that would allow central banks to focus more on supporting growth.

Firm Specific Outlooks

KKR

1. Market Assessment: KKR believes that the S&P 500 reached its lowest point in October 2022 and expects credit prices to stabilize. They don't advocate a general risk-on or risk-off approach in the current market conditions.

2. Four-Stage Model: KKR refers to a model where there is a rolling recovery and rolling recession happening across four stages - contraction, early cycle, mid-cycle, and late cycle. They suggest CIOs to focus on linear deployment, portfolio diversification, and suitable hedging.

3. GDP Growth: They forecast a stronger GDP growth in the US and China for 2023, but lower inflation than consensus estimates for the same year. They expect higher inflation in 2024 due to the reversal of disinflationary trends from the previous decade.

4. Earnings and Inflation: KKR predicts a decrease in earnings per share in 2023, followed by a restrained rebound in 2024. They expect higher inflation throughout this cycle.

5. Labor and Energy: KKR points out a structural labor shortage in the US and predicts sustainable long-term pricing for energy and energy-related investments.

6. Housing and Yields: They express caution about the US housing market but don't foresee a complete collapse. They also expect higher long-term yields in the US and Germany than what the consensus forecasts suggest.

7. Banking Crisis and Fed Rates: KKR thinks the regional banking crisis may continue and additional banks could be under pressure if the Federal Reserve doesn't cut rates in the near term.

8. Expected Returns and Opportunities: Despite the current market conditions potentially leading to lower expected returns this cycle, they believe opportunities can be found in alternative lending and cash as an asset class.

9. Regime Change Thesis: According to KKR, the Regime Change thesis is still valid. Factors like labor shortage, geopolitics, housing demand, energy transition, and fiscal impulse are contributing to inflation. However, they warn that traditional inflation hedges may disappoint, and they don't recommend making big bets on growth versus value stocks.

10. Cash and Risk Allocation: KKR suggests holding more cash and allocating risk elsewhere in this climate.

KKR Asset Allocation Strategy

1. Japan's Equity Market: Bullish due to attractive pricing, improving corporate governance, and an opening economy.

2. Collateral-Based Cash Flows: Overweight cash flows linked to nominal GDP, asset-based finance, real estate credit, and infrastructure.

3. Cash: Overweight due to rising yields.

4. Higher Quality Liquid Credit: Favor due to attractive returns and reduced default risk.

5. Flexible Capital to Preferred Securities: Consider debt-like instruments with equity upside.

6. Middle-Income Consumer: Positive outlook due to improving finances and supportive home values.

7. Non-Correlated Assets: Favor over traditional long/short hedge funds.

8. Short the USD: Due to trading at a premium and relative tightening in other economies.

9. Underweight Regional Banks: Expect challenges due to losses from duration and commercial real estate credit.

10. European Cyclicals: Bearish due to stronger euro, decarbonization, and de-globalization.

11. Turkey: Cautious due to high inflation and unorthodox monetary policy.

12. Businesses with High Staff Turnover: Emphasize worker tenure and aligned incentives.

Key Themes

1. Buy Simplicity: Favor high-quality liquid and private credit, mortgages, small and mid-cap stocks, and undervalued sectors.

2. Real Assets: Favor collateral-based cash flows.

3. Automation/Digitalization: Anticipate increased focus due to labor shortages.

4. Worker Retraining: Expect more opportunities as formal education becomes scarcer.

5. Resiliency: Focus on redundancy and resilience in various sectors.

6. Energy Transition: Consider as a significant investment theme.

Economic Outlooks

1. USA: Expect varied conditions across regions, growth to slow, and inflation to remain above Fed's target.

2. Europe: Expect slow but positive growth, inflation concerns, and deceleration in manufacturing sector.

3. China: Expect a lowered GDP forecast due to property sector issues and a consumption-led recovery.

Capital Markets

1. S&P 500: Expect decline in earnings per share (EPS) in 2023, rebound in 2024, and modest upside from current trading levels.

2. Interest Rates: Expect rate hikes in the U.S. and Europe, and easing and rate cuts in China.

3. Oil: Expect downward revision in oil price forecasts due to increased Russian crude production.

Takeaways from FAQ

1. Value across asset classes: Small-cap stocks, foreign stocks, credit investments, real assets, and cash offer good value.

2. 'Credit' sleeve of portfolio: Advise moving up in capital structure, favor high-quality CLOs, and see opportunities in high-yield debt market.

3. Inflation and Real Assets: New inflation hedges outperforming traditional ones.

4. Health of the global consumer: Global consumers are in better shape than appreciated.

5. Commercial Real Estate loans: Challenging outlook but market is more resilient compared to the Global Financial Crisis.

6. Longer-term issues: Concerns about inflation, demographic shifts, geopolitical tensions, and environmental issues.

KKR Summary

KKR's Global Macro, Balance Sheet, and Risk team (GBR) believes that a new regime for investing has begun, marked by several unique factors. These include supply-side shocks like tight labor markets, heightened geopolitics, and the energy transition, leading to more volatile and higher inflation. Another significant factor is increased fiscal spending in major global economies, contributing to the current economic cycle.

Despite monetary tightening, its impact on consumers is being mitigated by excess savings from the pandemic, limited variable mortgages, and a stable unemployment rate. The team offers several action items for investors, such as favoring credit over equities, investing in collateral-based cash flows, considering private equity and infrastructure markets, and exploring non-USA assets.

The team warns of potential pitfalls to avoid, including caution regarding office real estate in the United States, housing in China, and segments tied to manufacturing in Europe. The biggest risk is the need for further rate increases by central banks to control inflation. Despite potential headwinds, the team remains generally constructive on risk assets, emphasizing that the time to reduce risk has passed.

Refer a friend

BlackRock

• Stocks outperformed expectations in the first half of the year, with the S&P 500 delivering double-digit returns.

• Elevated inflation and the Federal Reserve's rate-hiking campaign have not dampened market performance.

• Technology shares, especially in the IT, telecom services, and consumer discretionary sectors, drove market performance.

• Investor caution is apparent, demonstrated by outflows from U.S. equity funds and inflows into money market funds.

• The recent banking crisis and the ongoing inverted yield curve signal recession concerns.

• There is potential for sidelined cash to be deployed into the market.

• As the market focus shifts from macro factors to stock-specific dynamics, opportunities may arise for active stock pickers.

• Defensive sectors like healthcare and well-priced cyclicals are seen as potential areas of interest.

• The return of alpha, or excess returns above the market average, is anticipated as stock differentiation increases in the post-COVID era.

• This environment of higher valuations, inflation, and interest rates is likely to benefit skilled managers, who are expected to play a larger role in generating alpha and contributing to investors' overall returns.

Apollo

Current Economic State

• The US economy has experienced a downturn in the past six months, with negative Gross Domestic Product (GDP) growth expected over the next nine months.

• High inflation of approximately 5% persists and is expected to continue until 2024, led by the Federal Reserve's tightening of monetary policy.

• Silicon Valley Bank's collapse puts pressure on regional banks to tighten lending standards and reduce credit availability.

Projections and Predictions

• A recession is imminent, with a 60% chance of a hard landing.

• There is ongoing debate between a potential soft landing or a hard landing.

  • Soft landing arguments: The impact on the commercial real estate sector will be smaller than the 2008 financial crisis, and the US banking sector's share of lending has decreased.

  • Hard landing arguments: The ongoing banking turmoil will have larger macro effects than anticipated, and high inflation and labor shortages will lead to higher interest rates.

State of the Capital Market

• Equity and bond investors have different outlooks; equity investors do not seem to anticipate a steep recession due to strong earnings, while the high-yield market indicates a harder landing.

• Bond issuance and lending markets are showing signs of recovery but remain below historical averages.

Non-Banking Financial Sources

• Due to challenges in bank lending and public capital markets, non-banking sources of funding, like private credit and asset-backed finance, are likely to be significant in supporting firms.

Potential Investment Opportunities

• In the current economic environment, it is advised to consider investments in asset classes with lower volatility and inflation sensitivity, such as private equity, private credit, and real assets.

• High interest rates and the demand for finance may pressure many companies to restructure their balance sheets, offering opportunities for private-equity investors.

• Opportunities also exist in distressed situations, take-privates, and carve-outs.

Looking Ahead

• For the remainder of 2023 and beyond, investors should consider their asset allocations.

• In the likely scenario of a hard landing, asset classes with lower volatility and inflation sensitivity, such as private equity, private credit, and real assets, become more appealing.

• Providing capital, especially debt and equity financing, can benefit investors in an environment where regional banks are under pressure and primary high-yield issuance is facing challenges.

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Outlook

The global economy is expected to slow down and become more divergent in the second half of 2023 due to persistent inflation and tight monetary policies by central banks. This challenging environment will require investors to seek opportunities that yield more than the risk-free rate of return. Varying strategies by region are recommended, with a focus on offensive approaches in Asia and defensive approaches in the United States and Europe.

Investment Opportunities

According to Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley Research, equities and high-yield bonds in developing markets pose higher risks. However, underappreciated opportunities can still be found, such as agency mortgage-backed securities. Despite their valuations approaching levels seen during the 2008 financial crisis, they are considered less risky due to more conservative lending standards. Additionally, declining US government bond yields make these securities attractive for investors.

Regional Differences

The global economic recovery will be sluggish, but significant regional differences will shape investment opportunities. Asia is expected to experience stronger growth, lower inflation, and easier policies compared to the US and Europe.

Key Points

• US and European equities may underperform: Company earnings are anticipated to fall short of expectations in the latter half of the year. Morgan Stanley has lowered its 2023 S&P earnings forecast and expects a rebound in 2024.

• Sector-level investments offer opportunities: Defensive stocks like consumer staples are favored over cyclicals such as consumer discretionary and technology stocks in the US. However, technology stocks in Japan, emerging markets, and Europe are expected to have upside potential. Healthcare is recommended across all regions.

• Japan and emerging market (EM) equities appear attractive: Favorable conditions, including stronger growth, lower inflation, easier policies, and reasonable valuations, may lead to double-digit returns in these markets over the next 12 months.

• Strong US dollar: The US dollar is expected to remain strong as investors seek its defensive qualities and positive carry, historically showing a negative correlation to equities.

• Normalizing commodities: After a breakout year in 2022, commodity markets are anticipated to return to more normal conditions. Slower economic growth typically leads to decreased demand for base materials and energy, resulting in flat prices for most commodities.

• Selective bond investments: Long-duration government bonds in the US, UK, and Germany could perform well due to attractive real yields, despite high inflation and poor carry. Investment-grade bonds may also provide positive returns in developed markets with soft economic growth.

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JP Morgan

Market Insights

The outlook for 2023 suggests that it has been a better year for markets than initially expected, with economies performing relatively well. While manufacturing has faced challenges due to weaker demand and rising costs, the service sector has remained resilient. Factors such as a strong labor market, pent-up savings, and the desire to compensate for missed experiences during the pandemic have outweighed the impact of higher costs and interest rates.

Market expectations have shifted towards a scenario where the economy avoids a recession and inflation falls back to target levels. Inflation is anticipated to decrease quickly, allowing central banks to focus on supporting growth instead of driving a recession. However, some concerns remain, and the likelihood of a recession is still considered probable. The mid-year outlook emphasizes the importance of portfolio diversification against recession and inflation risks, adopting a relatively defensive approach to stock allocation, and considering dominant secular themes in a shifting economic landscape.

The economic toll of recent banking stresses is also a concern. While swift liquidity support and takeovers have prevented a further escalation, the perception of market complacency regarding banking troubles may be misplaced. Bank lending surveys indicate that corporate lending standards have tightened, which historically has been accompanied by a recession. Balance sheet constraints and a bleak outlook for real estate suggest that risk tolerance at banks will remain low in the near term.

The behavior of the labor market is another uncertainty. While firms have cut back on investment plans, employment intentions have remained relatively robust, potentially due to challenges in finding staff post-pandemic. However, it is uncertain if this trend will continue, and a significant rise in unemployment may still be forthcoming. Central banks face a difficult balancing act, needing the labor market to weaken to drive down inflation but reluctant to be the cause of rising unemployment, especially in the run-up to national elections.

Inflation is expected to cool on a headline basis, with base effects and dropping energy and food prices benefiting Europe. However, core inflation is not projected to quickly return to target levels. Buoyant demand for services, a tight labor market, and ongoing wage pressures are likely to keep upward pressure on costs and prices until a recession occurs. The long-term concern is that goods price inflation may not remain as low and stable as in the past due to higher input costs and reduced disinflationary effects from globalization.

The energy situation in Europe is more favorable than anticipated, with storage tanks at high capacity and falling gas prices driving down inflation and reviving consumer confidence. The prospects for energy problems next winter are considered less likely unless there are severe temperature conditions. Efforts are also underway to establish domestic renewable energy solutions.

China's recovery has shown similar patterns to other regions, with improvements in the service industry and more muted investment activity. Real estate challenges and limited financial buffers have affected private sector confidence. While growth expectations for China may fall short, it is premature to discount the entire year. Moderate government debt levels provide room for fiscal stimulus, and low inflation allows the People's Bank of China to cut policy rates to support households and businesses.

Equity Allocations Resilience

• The current stock market rally is due to the rising hopes of a positive economic scenario.

• Investors should focus on high-quality companies, strong dividend payers, and regional diversification to enhance the resilience of equity allocations.

• Quality is important as markets tend to reward companies with strong balance sheets and experienced management teams, especially during uncertain times.

• Including dividend-paying stocks can help buffer against volatility. Sectors like healthcare and utilities often offer strong dividend opportunities.

• It's risky to concentrate portfolios in a single equity region. Diversifying by allocating more to Europe could be beneficial.

• Tech stocks may not perform well during a US recession due to a potential pullback in spending.

Portfolio Diversification

• In 2022, stocks and bonds both experienced significant losses due to inflation reaching 40-year highs.

• Given the likelihood of persistent above-target inflation, investors should consider diversifying their portfolios to include alternative assets like timber, infrastructure, real estate, and hedge funds.

• Relying solely on the negative correlation between stocks and bonds may not be sufficient for portfolio diversification in the face of inflation volatility.

Secular Investment Themes

• Factors such as climate change, pandemic impact, and geopolitical events have led to scarcity in various areas.

• Scarcity in clean energy, materials, food and water, and labor are creating investment opportunities in renewable energy, efficiency, electrification, sustainable transport, construction, domestic processing and recycling of critical minerals, sustainable agriculture, water management, reforestation, and services for older populations.

Central Scenarios and Risks

• Central Scenario: Moderate inflation and mild recessions are expected. Central banks may pause their hiking cycles with modest rate cuts anticipated in 2024. Equities may face challenges with higher quality stocks outperforming.

• Downside Scenarios

  1. Growth and inflation decline simultaneously prompting central bank support leading to deeper recessions.

  2. Sticky inflation prevents central banks from intervening due to persistent price pressures. Bonds fail as diversifiers, equities experience negative total returns, and USD strengthens against cyclical currencies.

• Upside Scenario: Resilient growth and cooling inflation could create a favorable environment. Stocks might see positive earnings expectations and rebounding valuations.

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Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

Large positions are reserved for large pools of capital, which means asset managers, family offices, and UHNW individuals.

Investors with larger pools of capital can buy up more shares of a company and exert some degree of influence. Executives generally play ball with investors because they know if enough large investors get together and make a fuss they could lose their jobs.

Investors that focus on building up influential equity positions and seeking change are known as “activist” investors.

Activist investors will quietly buy up minority interests in companies with the goal of gaining influence through their equity position and pushing for changes at the company. These changes could include gaining seats on the board, pushing for changes in management, influencing strategic direction, capital structure management and more.

The Birth of the Activist

87 year-old Carl Icahn is one of the most famous investors in history. He started his career on Wall Street in 1961 as a stockbroker, later pivoting to trading options. In 1968 he went off on his own and started a brokerage firm called Icahn & Company. Icahn & Co. started off as an options brokerage specializing in arbitrage.

How did an options broker progress into becoming one of the most notorious “corporate raiders” of all time?

In the 60s and 70s, Icahn engaged in convertible arbitrage, exploiting inefficiencies between a company’s stock and its warrants or convertible debt. Over time, this strategy evolved to arbitraging closed-end mutual funds and their underlying portfolio.

Mutual funds are just portfolios of securities with money managers at the helm. Open-end funds will issue or repurchase shares to meet demand from investors, and trade at the fund’s Net Asset Value (NAV) per share.

Closed-end funds on the other hand have a fixed number of shares, and shares are purchased from other investors the same way you would buy or sell a stock. As a result, closed-end funds can trade at a discount or premium to NAV.

Icahn would long closed-end funds trading at a significant discount to NAV, and short the securities in their portfolios. This hedged out the market risk of their position. As the discount to NAV compressed, Icahn & Co. profited. The risk was that the discount widened, forcing Icahn to close out positions at a loss.

To close the gap between NAV and the price of the units of the mutual funds, Icahn would push for the liquidation of these funds. Even the prospect of liquidation could cause the market to reprice the units and generate profits for Icahn.

Over time, apparently Icahn & Co. realized the same line of thinking could be applied to undervalued companies. Icahn the activist was born.

Icahn sought to “control the destinies” of companies by buying significant stakes in their equity and pushing for actions that could yield profits for his stake, such as the sale or liquidation of the company, or the purchase of Icahn’s shares.

Proxy Fights

A key tool in the activist investor arsenal is the proxy fight.

A proxy fight is what brought Icahn an early win in activist investing. In 1977 Icahn began building a position in appliance manufacturer Tappan, a company he believed was undervalued and a strong candidate for a takeover. After Icahn’s discussions with management about selling the company fell apart, Icahn took his fight public and sent a letter to shareholders.

He waged a proxy fight to get himself a seat on the board and push for a sale, merger, or liquidation of the company which he believed was trading at a 45% discount to its share price. Tappan was eventually sold at nearly double the price Icahn paid, netting him a cool $3mm and paving the way for the future of Icahn & Co.

In the decades that followed, Icahn amassed a multi billion dollar war chest from takeovers and activism. Recently, the hunter has become the hunted as short seller Hindenburg Research called out IEP for its poor performance, overstating their marks, and paying an unsustainable dividend.

Icahn Enterprises LP

Icahn Enterprises LP (“IEP”) is a holding company founded in 1987 (began as American Real Estate Partners). IEP consists of various businesses, including Icahn’s investment funds, an energy company, food packaging, real estate, automotive and more.

IEP looks for companies to invest in and aims to realize intrinsic value through a sale, replacement of management, or buyout. IEP also acquires companies for its own portfolio, and invests in the debt of distressed companies.

Icahn structured IEP as a master limited partnership (“MLP”), which gives the general partner (Icahn Enterprises GP) total control over IEP, including electing the Board.

Translation: Icahn has thrown enough captains overboard in his career and knows how to avoid joining them (with tax benefits).

IEP is, for all intents and purposes, Icahn’s very own investment vehicle. Carl Icahn and his son Brett Icahn own 84% of the company. That hasn’t stopped investors from wanting to ride along with the famous investor.

It’s a bit ironic that Icahn has been subject to a public short report on his own closed-end holding company, considering that his arbitrage on the discount to NAV of closed-end funds is where he got his spark for activism.

Is there a comeback story for the 87-year old, or is this the end of the road?

The Situation

A report by Hindenburg Research brought Icahn Enterprises into the discussion. The question is whether the criticisms are warranted, or if Hindenburg was able to use their influence to profit on their shorts while creating a buying opportunity somewhere in the IEP cap stack for the rest of us.

There are some obvious points that stick out. The first being that IEP still trades at a huge premium, even compared to its own “overstated” marks. Indeed, even Icahn gives IEP an indicative NAV of $15.63, while IEP units trade at $26.67 (1.7x NAV!).

If you’re thinking “what an obvious short”, we will have to stop you there. Icahn owns about 85% of IEP, and if sufficiently motivated he could find a way to buyout the remaining units whether that’s on his own or through a strategic partnership. Sure, he may not want to eat the cost of paying such a substantial premium to NAV, but there is a floor price where he would elect to buyout the remaining stake.

We don’t need to do a ton of work to recognize that the stock is overvalued. The question is why?

The answer is two-fold:

1. Icahn’s star power

2. Dividend yield

IEP is a chance for investors to participate in Icahn’s investments. His “star power” is critical to maintaining investor interest, which Hindenburg highlights as being almost entirely retail investors. Icahn is likely aware of this, given his participation in a documentary about himself last year (let us know if you’ve seen it).

The other, and perhaps more significant, piece of the equation is the whopping $2 quarterly dividend which now represents a 30% yield for the remaining IEP holders. There is still a steep drop before IEP trades at NAV, so maintaining this dividend is crucial to retain the elevated valuation. To maintain the dividend, IEP has been issuing units at-the-market. While Hindenburg points this out as being “ponzi-like”, the fact remains that Icahn has been able to issue shares at a substantial premium to NAV. You can’t exactly blame Icahn for capturing the premium if it exists!

The Business

IEP looks for undervalued companies to invest in, influence, and potentially takeover entirely. IEP makes distributions to its investors rather than keeping the cash in the business. Icahn own most of the shares and continues to accumulate more as he takes his dividend payments in more shares, paying cash only to the small percentage of outside investors.

The key segments include:

• Investment: private investment funds of Icahn and his family members, valued at $4.2B. These funds invest across the cap stack

• Energy: Consists of 71% majority ownership of petroleum business CVR Energy which is the GP and 37% owner of CVR Partners LP, a publicly traded limited partnership in the nitrogen fertilizer businesses

• Automotive: Retail and wholesale of automotive parts, as well as auto repaid and maintenance

• Other: food packaging, real estate, pharma, home products

IEP operates across a wide range of sectors, but not all sectors are equal when it comes to the bottom line.

The only segment that generated material, positive net income in 2022 was Energy. On an Adjusted EBITDA basis, other segments were slightly positive, but Energy was still the only significant contributor. 2023 has been more of the same, with CVR energy putting the team on its back. Automotive segment subsidiary Auto Plus filed for bankruptcy in January 2023. YTD March 31, 2023 returns for the investment funds were -4.1%. 2022 returns were +9.6%.

The Cap Stack

IEP has debt at both the holdco and opco levels.

HoldCo interest is ~$290mm per year, which is unlikely to be covered by cash generation at the HoldCo level. The HoldCo generates cash through dividends and distributions from its subsidiaries and equity/debt financings.

Based on IEP’s NAV calculation the HoldCo has a 48% LTV (2.1x coverage). The HoldCo debt is well covered even in a downside scenario. Interest on the debt may not be covered by distributions, but the company has substantial liquidity to buyback debt at a discount (a $500mm debt buyback program was announced in May) to reduce the interest burden.

Due to the significant ongoing dilution to unitholders, substantial premium to NAV, risk of margin call on units Icahn has pledged for a personal loan, as well as headwinds for IEP’s subsidiaries, we are not bullish on the units. Should the situation worsen, it’s possible that IEP may reduce its dividend which could push the valuation closer to NAV. Icahn is also 87-years old, and his “star power” is key man risk (the ability to invest alongside Icahn is a major draw for investors). There is a succession plan in place to have Carl Icahn’s son Brett Icahn take over as Chairman and CEO.

The HoldCo debt on the other hand is well covered and provides 10-11% yields. A combination of Icahn’s personal financial wherewithal, opportunities to monetize subsidiaries (including the investment segment), a long liquidity runway, and attractive debt coverage means that IEP’s unsecured debt is likely money good. For what it’s worth, Hindenburg later took a short position on IEP’s bonds and seems to have done poorly on that trade.

Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

Deciding how much size to put on is a function of expected return, risk, portfolio composition, broader fund strategy, and liquidity. The larger the fund or the less liquid an investment, the more liquidity becomes a concern. A large fund may not want to expend the time to take on a smaller position because it doesn’t move the needle for their returns. Sizing into a less liquid position could create difficulties in exiting the position later.

One of the key benefits of trading sovereign debt and currencies is the ability to size up. George Soros famously made an estimated $1B betting against the British pound in 1992 in what is known as “Black Wednesday”. 5 years later, George Soros, Tiger, and a slew of other hedge funds found themselves making a similar bet in another part of the world - Asia.

The risk of an adversarial investing approach is that, well, you may end up going up against the full weight and force of a country’s economic power.

These hedge funds entered into a carry trade where they borrowed yen at a 3% interest rate and invested in baht deposits that earned a 17% interest rate. At the time, the baht was pegged to the U.S. dollar. As the yen strengthened against the U.S. dollar, the cost of repaying the yen loan would effectively increase.

Hedge funds would engage in “speculative attacks” by putting in huge sell orders on baht. The Bank of Thailand defended by asking for intervention assistance from regional central banks, and engineering a squeeze by preventing local banks from supplying baht to foreign companies. This led to significant losses for hedge funds that had borrowed baht in the offshore market. They not only had to pay extraordinarily high interest rates, but they also had to buy baht at a time when it was scarce and expensive.

Being of the view that the fundamentals had deteriorated, hedge funds held on to their short bets. This tussle between speculators and central bankers continued for some time, and while speculators may have been contributors to the crisis that followed, the underlying economic and policy errors were the root causes of the Asian Financial Crisis (“AFC”).

Global Economies are Interconnected

Studying the failures of cities, states, and nations has been proven to be a rewarding endeavor, whether you’re a speculator, central banker, or an informed citizen.

Today, trust in institutions across the globe is lower (or at least louder) than ever, even inside some of the world’s largest economies. A common subject of discussion revolves around debt, including debt owed by households, corporations, and governments. When someone takes on too much debt and can’t pay it back, they have to restructure their obligations. It’s often a lengthy and painful process with few winners.

That begs the question: why do we need debt at all? That’s easy. Without debt, there would be no fees for bankruptcy professionals.

Another good reason is being able to bring forward your future earnings by borrowing against them. You can borrow money today as long as you promise to repay it along with some pre-determined interest rate. At scale, we have “debt markets” where companies, governments and municipalities borrow by issuing various debt securities.

One person taking out a mortgage to buy a house is relatively simple to understand. When you add up all the components of international debt markets, including primary and secondary markets, all the many types of debt securities, collateral, and borrowers across the world, it becomes hard to pick apart exactly what might break and send the financial world hurtling into the sun.

The Institute of International Finance estimates the global debt sat at $305 trillion at the end of Q1 2023. Emerging markets debt crossed $100 trillion for the first time.

Global economies are deeply interconnected. To simplify, think of countries as one giant family. Each branch of the family is good at certain things, such as finding resources like oil or building things like phones. Since we all need oil and phones, one family sells to another.

Maybe one branch of the family wants to buy a house or cover some expenses when budgets get tight, so everyone gets together and lends them some money. Perhaps some members of the family are doing quite well so they decide to invest in the ventures of other members. Poor family members can go to the wealthier ones and receive aid to help with things like healthcare and education. Sometimes families get into fights and seek help to resolve them.

These transactions make up the broader economic relationship between one big family, including trading goods and services, lending and borrowing money, investing in ventures, and providing aid.

While wealthier economies are more insulated from the economic impacts to poorer economies, the interconnected nature of the world means that there may still be an impact on goods, services, and credit markets.

In a world of high leverage, declining trust, and changing economic tides, understanding how countries fail is more important than ever.

By the way, we are going to be posting daily on Instagram going forward. Join us (@capstack_)

The Miracle

It’s common for periods of prosperity to precede periods of stress or distress. People may buy too much home or car when they receive a good bonus. Corporations may build up too much capacity when business is booming.

Before the AFC, Southeast Asian countries experienced a number of prosperous years. It was so prosperous that the period leading up to the AFC was referred to as the Asian Economic Miracle (“AEM”).

U.S. recession in the early 90s led to investment dollars flowing into rapidly growing economies such as Thailand, Indonesia, Malaysia, and Philippines. Southeast Asian countries, with their rapidly growing economies and potential for high returns, became attractive investment destinations. This influx of capital led to economic expansion and an increase in foreign direct investment in the region.

To attract investment and stimulate economic growth, the governments of these countries took on large-scale development projects for public works and infrastructure.

These projects, such as building highways, airports, and industrial zones, were undertaken with the expectation that they would generate good returns in the long run despite a vague possibility of turning a profit. When these investments proved to be less profitable than anticipated, they led to overcapacity and inefficiencies.

As capital flowed into the Southeast Asian economies, the increased investment and export-oriented growth led to substantial trade surpluses and current account surpluses. However, as the economies grew and domestic consumption increased, imports also rose.

When export demand weakened in the face of global economic slowdowns, these surpluses turned into deficits. This shift exposed vulnerabilities and increased dependence on foreign capital.

The capital inflows during the AEM resulted in the expansion of credit portfolios, with banks and financial institutions lending significant amounts of money to both corporations and individuals.

However, as economic conditions deteriorated and borrowers faced difficulties in repaying their loans, refinancing became a common practice. Companies and institutions that were already indebted were provided with additional loans to cover the interest payments on previous loans.

Unsurprisingly, a cycle of paying off loans with new loans is unsustainable. The chickens come home to roost eventually.

The combination of overcapacity, declining export competitiveness, unsustainable debt levels, and the sudden loss of investor confidence led to sharp currency devaluations, stock market crashes, and severe economic contractions in the affected countries.

As both a cautionary tale and for personal entertainment, we wanted to look at the projected forecasts immediately before and after the crisis for various countries.

These numbers tell a startling story: financial and economic outlooks can deteriorate overnight.

As mentioned earlier, plenty of “smart money” was already betting against the pre-crisis forecasts, but most people probably didn’t know what hit them.

The Crisis

On July 2, 1997, the Thai government decided to let the baht float freely instead of maintaining its fixed parity with the US dollar, which led to the devaluation of the baht.

The central bank of Thailand had secretly used foreign exchange reserves to defend the baht, but it wasn’t enough. As the situation worsened, the government eventually abandoned the fixed exchange rate regime.

The devaluation of the Thai baht sent shockwaves throughout the region, affecting countries with similar economic characteristics such as Indonesia, Malaysia, the Philippines, and South Korea. The crisis quickly spread, intensifying the contagion effect. Investors started to withdraw their capital from Southeast Asian countries and shifted their investments to safer havens in the West.

The currency devaluations in the affected countries were drastic.

• Thai baht, which had been pegged at 26 USD/THB, depreciated to 53 USD/THB

• Indonesian rupiah dropped from 2,400 USD/IDR to 14,900 USD/IDR between 1997 and June 1998.

• South Korean won dropped from 900 USD/KRW to 1,695 USD/KRW by the end of 1997.

In response to the escalating crisis, the International Monetary Fund (“IMF”) provided financial assistance to Thailand, Indonesia, and South Korea. These countries received a combined bailout package of $118 billion from the IMF to stabilize their economies and restore investor confidence.

However, the financial assistance came with strict conditions, including the implementation of stringent spending restrictions and structural reforms.

An impressive display of patriotism came from South Korea. South Korea received a $58B loan from the IMF, but the loan required interest rate hikes, fiscal austerity and structural reforms. Their unemployment rate tripled. The government asked Koreans to donate jewelry to help repay the loan. Wedding jewelry, family heirlooms, medals, trophies, and anything else with gold was given by the Korean people. Within a few months, $3B of jewelry was provided to the government. The loan was repaid in three years.

The Crunch

During the Asian financial crisis of 1997, one of the major consequences was a severe credit crunch that affected the affected countries.

Bank Insolvencies

As the crisis unfolded, many banks in the affected countries faced insolvency due to their exposure to risky loans and speculative investments. The sharp depreciation of currencies and the collapse of asset prices led to a significant erosion of bank capital. As a result, these banks became reluctant to extend new loans or maintain existing credit lines, leading to a contraction in credit availability.

Capital Flight

The crisis triggered massive capital outflows from the affected countries as foreign investors lost confidence in the stability of their financial systems. This capital flight further strained the banking sector and reduced the available funds for lending. The scarcity of foreign capital and the need to repay external debts made it challenging for domestic banks to access international credit markets.

Risk Aversion + Higher Rates

The credit crunch was exacerbated by a general increase in risk aversion among lenders. Financial institutions became wary of extending credit to borrowers in the affected countries due to concerns about their ability to repay. This increased risk perception led to higher interest rates, making borrowing more expensive for businesses and consumers. Higher interest rates further dampened investment and consumption, exacerbating the economic downturn.

Corporate and Household Defaults

As credit became scarce and borrowing costs rose, many businesses and households faced difficulties in servicing their existing debts. This led to a significant increase in corporate bankruptcies and loan defaults. The inability of borrowers to meet their repayment obligations further weakened the banking sector and deepened the credit crunch.

The Impact

The AFC had severe implications for the prices of goods and services due to currency devaluation. Inflation varied across countries, depending on the fiscal and monetary policy responses of the respective governments. Inflation eroded the real value of income and household savings, leading to higher prices and lower real wages. These effects spread rapidly and had a significant impact on individuals and the overall economy.

Bankruptcies during the AFC had adverse effects on employment and earnings. The crisis affected both rural and urban employment in countries like Indonesia and Korea. While rural employment expanded during the crisis, urban employment growth slowed down.

The Aftermath

The credit crunch gradually eased as the affected countries implemented reforms, recapitalized banks, and restored investor confidence. However, the recovery was a gradual process that required a sustained commitment to sound macroeconomic policies, financial sector reforms, and regulatory improvements. The crisis highlighted the need for stronger risk management practices, improved banking supervision, and better corporate governance to prevent future credit crunches.

Households were advised to make adjustments in their consumption and savings habits, increase their work efforts, consider migration for higher-paying job opportunities, and utilize public sector services. These measures aimed to help households cope with the economic challenges.

Labor management practices, including the formation of unions, played a crucial role in minimizing strikes and layoffs. Agreements between unions and employers were implemented to facilitate adjustments that would minimize the risk of job losses, ensuring job security for workers.

Fiscal adjustments were implemented to address the impact of the AFC. Budget constraints were imposed on investments and defense expenditures, while maintaining government spending on salaries, social services, and the recapitalization of financial institutions.

Retirement funds were introduced, requiring workers to contribute a portion of their salary towards building savings for their retirement. Additionally, unemployment insurance and assistance programs were established to provide support to those who lost their jobs. Examples include offering loans for individuals to start small businesses and providing financial aid to unemployed individuals.

Price controls and subsidies were implemented to manage inflation and ensure the affordability of essential goods. Government subsidies were utilized to control the prices of commodities such as livestock feed, gasoline, and fertilizers.

While the IMF bailout packages helped stabilize the economies and ease the immediate impact of the crisis, the road to recovery was long and challenging. The affected countries underwent painful economic adjustments, including austerity measures, corporate restructuring, and financial sector reforms.

The Winners

We’re a publication about troubled situations, so naturally we had to keep our eyes out for who the winners were despite the fallout. Details on specific winners from the AFC are not widely well-documented. Given the disruptive and destructive impact of the crisis on the social and economic fronts, we are unlikely to find significant winners who are going to hop on a podium and divulge the stories behind their victories. Recollecting past discussions with people in the industry, there were a number of private equity firms who took the opportunity to purchase Asian assets in the years during and following the crisis (from memory, Cerberus had a notable presence in Korea).

Various accounts online state that Soros made ~$1B from his bet against the Baht. Julian Robertson’s Tiger fund was also involved, as well as other billionaire investors such as Bruce Kovner and Lee Cooperman. Surely this gang of jolly good fellows made off quite well on their bets against the baht.

Beyond investing, sovereign distress is a topic that affects the lives of millions of people all over the world. The financial and economic situations of a country have a deep impact on the lives of its citizens and their future prospects.

Well-managed countries are able to invest in infrastructure, education, healthcare, and overall development of the basic things those of us in functional societies take for granted. Countries where political leaders exploit the finances of a nation for their own gain should not be surprised to find themselves at the negotiating table with lenders from all over the world.

Since the AFC, distressed investors, lawyers, central bankers, and global policymakers have become smarter and better resourced. Laws in many jurisdictions have also adapted to prevent certain types of attacks, although things do slip through the cracks as with anything.

Thanks for reading. There is a ton more we can cover on the topic of sovereign distress in addition to our corporate coverage. It’s useful to have a detailed understanding of financial history in your back pocket. At the same time, live corporate situations are also important (and opportunistic).

Drop us a comment if there’s a preferred direction you want us to take things otherwise we’ll continue to mix it up as we go based on what looks interesting to us.

Cheers.

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P.S. We are still doing that piece on Icahn. Took more time than we expected. Coming soon.

Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

Typically, companies requiring a financial restructuring will have an Enterprise Value lower than the value of the debt obligations owed.

The fulcrum security is where value “breaks” or “runs out” in the cap stack. Where the EV = cumulative debt as per absolute priority.

The fulcrum is important in a restructuring because the creditor group involved in this security will be able to exert the most influence over the process. Generally speaking, creditors that are below the fulcrum security in payment will receive little to no value, and creditors above the fulcrum will typically receive a full recovery because they are “in the money.”

Let’s go through an example using a hypothetical cap stack for a company we will affectionately name “BadStack.”

BadStack experienced record profits during the pandemic. With cheap access to capital and ambitious growth plans, the company completed huge capital raises successfully. As the market turned the company’s prospects worsened and profitability took a hit. EV fell 40% and the value of its equity as well as junior debt fell.

BadStack’s debt burden eventually became untenable and the company was forced to restructure its debt. At BadStack’s current EV, parts of the cap stack are underwater.

The most senior parts of the cap stack (the term loan and 2nd lien debt) are fully covered and receive a 100% recovery. The subordinated bonds, preferred equity and common equity are fully wiped out.

The senior bonds are the fulcrum security - the last lenders to receive some value. The senior bonds are where BadStack’s value “runs out.” They do not get a 100% recovery, and they do not get fully wiped out. In this hypothetical scenario let’s assume they achieve a recovery of 75%.

How to Identify the Fulcrum Security

A quick check you can do is to look at the trading prices of the bonds. If bonds are trading at 75, creditors expect to receive 75 cents on the dollar when the bonds mature or in a restructuring. Generally, this approach is for bonds trading below 80 as the market is pricing the bonds based on recovery value. For bonds above 80, they may be trading at that price to adjust for yield relative to similar credits (due to changes in interest rates). This is not a hard and fast rule but it can work for a quick n’ dirty approach.

Another approach would be to analyze the company’s credit ratios, such as Debt to EBITDA.

For example, let’s say a company is valued at 5.0x EV/EBITDA and has a Debt / EBITDA of 7.5x. The most junior debt piece where value runs out (where Debt/EBITDA reaches 5.0x) would be the fulcrum.

More involved approaches would entail constructing valuation models and analyzing a company’s debt capacity. Valuation is an essential component of restructurings because it determines what recoveries are available to creditors and the fulcrum security. Given its importance, it’s common for creditor classes to disagree on the valuation.

A “valuation fight” occurs when creditors litigate to determine the outcome of a restructuring’s plan valuation, which determines the recoveries each creditor receives.

This closes out the first of our educational series on restructurings and distressed debt.

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Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

You sell something you don’t own by borrowing it, with the hopes that when the price falls you can buy it back for less than what you paid and return it to its rightful owner.

A “naked” short is when you sell short an asset without borrowing it from someone else. That means you aren’t sure you’ll be able to find the asset and deliver it in time. Assets facing a surge in demand or have few sellers could be difficult to purchase or borrow. Naked short selling is generally considered illegal in the U.S., but it can slip through the cracks.

Before we get into why we’re telling you all this, let’s travel back in time.

Philip Falcone was born in a small-town in Minnesota in a household of 9 children. He went to Harvard on a hockey scholarship and started his career on Wall Street in high-yield bond trading at investment bank Kidder Peabody.

After rising up the ranks at Kidder Peabody, Falcone went on to work at Wachovia and Barclays where he honed his craft trading distressed debt.

The late ‘90s and early 2000s provided ample opportunity in the distressed space. The Asian Financial Crisis began in July 1997, starting in Thailand and spreading to other East Asian economies. These economies faced severe currency devaluation, a collapsing stock market and widespread bankruptcies.

This crisis reduced demand for crude oil, a key export for Russia, a country that was already facing economic challenges of its own. In 1998, the Russian economy collapsed in what’s known as the Ruble crisis. In addition to a devaluation of the Russian Ruble, Russia defaulted on domestic debt. Inflation skyrocketed and living standards plummeted. This led to the resignation of President Boris Yeltsin in December 1999 and brought Vladmir Putin into power.

From 1998 - 2000, Falcone was managing high yield trading and distressed at Barclays. By 2001, Falcone was ready to go off on his own and started a hedge fund called Harbinger Capital with a $25mm investment from Harbert Management.

According to Forbes, Falcone took home $1.7B after betting against the housing market in 2007. In 2008, Harbinger was up 43% by the end of June. The fund’s AUM peaked at $26B. By the end of November, the fund was down 23% for the year and redemptions were restricted.

In 2012, Falcone and Harbinger were charged with securities fraud by the SEC for “illicit conduct that included misappropriation of client assets, market manipulation, and betraying clients.”

Apparently, Falcone borrowed $113mm from his hedge fund to pay personal taxes. Oops!

Despite the entertainment value of exploring this maneuver, it’s not the reason for today’s post. Today’s post is also not about his little redemption scheme that benefitted certain investors over others, and not even the billions of dollars he torched in his investment in telecom company LightSquared.

What we’d like to bring into focus is that the SEC also alleged Falcone and two of his deputies manipulated a series of distressed high-yield bonds by engaging in an illegal “short squeeze.”

From 2006 to early 2008, the folks over at Harbinger constricted the supply of bonds issued by MAAX Holdings, a distressed manufacturer of bathroom products (we will refrain from making a snide remark here). Harbinger had built up a large position in MAAX bonds which were subsequently shorted by a “Wall Street financial services firm” (*ahem* Goldman). Apparently, Falcone decided to “seek revenge” and bought every bond on the market, including from shorts.

Harbinger owned 13% more than the total available supply of MAAX bonds. They had purchased more bonds than MAAX had ever issued. Then, Falcone locked the bonds in a custodial account so his brokers couldn’t lend them out.

If that wasn’t enough, Falcone demanded that shorts settle (deliver) the bonds. When the short sellers went out into the market to find bonds, they learned they weren’t available. As shorts bid for the bonds, the price shot up. He started wheeling and dealing with shorts and selling at high prices.

We have dubbed this (illegal) move:

Falcone… Punch!!!!

Why are we bringing up a 10 year old story?

A headline from 2011 reads “Phil Falcone: This Generation’s Carl Icahn.” Whether it was a puff piece, or written by an overzealous intern at Business Insider, this headline may end up being unintentionally prescient.

Earlier this month, short sellers Hindenburg Research shorted Icahn Enterprise’s (IEP) bonds. This comes after Hindenburg accused IEP of being ponzi-like. These bonds don’t trade much, and there’s high short interest.

To be clear, we’re not insinuating Icahn is engaging in a Falcone Punch (since of course, that’s illegal). The dynamics at play here (high short interest, low availability) could create quite the short squeeze in IEP bonds.

We’re taking a closer look at IEP out of personal interest. If you want us to write up a deep dive, drop us a like/comment or give this article a share to let us know.

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Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

Over the years, VICE received investors ranging from Wall Street to Rupert Murdoch to Disney. In 2017 the company received funding from private equity giant TPG that valued it at over $5.7 billion. Not bad for a “fringe magazine”.

This investment came one year after VICE is said to have turned down a buyout offer from Disney for $3.5B.

They should’ve taken the deal.

Early morning on Monday May 15th, 2023, VICE media filed for bankruptcy in the Southern District of New York. Looks like Mickey Mouse dodged a bullet.

The Situation

Critics besieged the failing media company on Twitter as rumors of its bankruptcy circulated, citing VICE’s shift away from the punk culture it once represented to one that caters to “the establishment.”

What critics are ignoring, however, are the years-long struggles of many media companies. As social media giants ate away at advertising revenues over the years, traditional media was forced to adapt or die.

Investors betting on traditional news outlets seizing market share from social media companies were wrong. Media companies moved to a subscription model, got acquired by larger players, or sputtered along until they ran out of money.

Just last month, Buzzfeed shuttered its news arm and laid off 15% of its staff. Over 20% of distressed bonds in the Morningstar High Yield Index are media companies (based on par value).

VICE had been hemorrhaging cash for years and had to tap investors on the shoulder for more capital again and again.

Lack of profits, ballooning debt obligations, a failed SPAC and a failed sale process last year brought the company to a breaking point. In December 2022 VICE Media failed to repay its Term Loans as they came due.

Yes — VICE had already defaulted on a debt maturity six months ago. VICE received multiple forbearances from lenders who gave VICE additional time, capital, and the option of paying interest in-kind.

Why do lenders throw good money after bad? They often don’t have a better option. If lenders are planning to take over a distressed company, they’ll have to finance its operations until the company can generate cash or find another source of capital. Extending additional financing and waiving certain obligations gives both creditors and debtors time to explore alternatives (such as a sale) and prepare for a bankruptcy process.

Adequate planning minimizes the time spent in bankruptcy which reduces expenses and preserves value. Additional financing may also be required to protect priority interests (a topic for a future post).

VICE eventually had to pay the pied piper. Vendor payments were overdue, contracts were falling apart, and news of the company’s distress was spreading.

VICE’s largest unpaid vendor obligations include an IT company in New Jersey called Wipro owed $9.9mm, and CNN to the tune of $3.8mm. Even restructuring advisor FTI Consulting is owed $1mm. These vendors will be unsecured claims (translation: they’re S.O.L.).

VICE was mired in controversy throughout its history. VICE’s Chief Restructuring Officer cites the termination of an internal deal between Vice World News (“VWN”) and VICE as being a cause of its liquidity crunch.

VWN was supposed to pay VICE $34mm in January and instead handed them a termination notice. It turns out VWN had a third-party, founding partner who wanted out. The parties came to a settlement of $50mm payable in two instalments, but it was too little too late.

The VWN delayed payment and a judgment in favor of Wipro for its unpaid fees were the straws that broke the proverbial camel’s back but make no mistake — VICE has been a troubled company for years.

The Business

VICE is a global operation with a complicated organizational structure.

Its key business segments include

• The Studios Group: Production studio for TV, documentary, film, commercials, and music videos. Operates through VICE Studios (documentaries and scripted TV) and Pulse Films (commercials, music videos and scripted content)

• Publishing: Online publishing business operating through “VICE”, i-D, and Refinery29. Distribution through VICE’s own websites and channels as well as social media platforms. Revenue in this business comes primarily from advertising.

• VICE TV: Cable TV channel offering news, docs, films and reality TV. Vice TV licenses content worldwide and also earns revenue from affiliate fees and advertising.

• Virtue: In-house creative ad agency that earns revenue from working with brands to develop creative and brand strategy as well as production revenue for producing content for clients.

• VICE News: News platform for youth audiences.

One of the most critical parts of VICE’s operations is its network of freelancers. The debtor entities make use of over 1,800 freelancers to produce its content. That’s three times the number of employees (another ~700 work at non-debtor entities).

The Bankruptcy

VICE and its lenders went through an extensive sale process and negotiation before the bankruptcy filing.

VICE pre-negotiated a deal whereby secured lenders will credit bid at a price of $225mm.

Distressed companies may be on fire (the dumpster kind) but they don’t stop, drop, and roll when in bankruptcy. Preserving value means operations must continue. To fund operations and pay for expenses incurred in the bankruptcy process, companies get access to a special type of debt financing known as Debtor-in-Possession (“DIP”) Financing.

DIPs come with higher fees and higher interest rates with a superpriority claim and a wide array of terms and limitations that give DIP lenders additional control. These factors mean that DIPs can prove to be quite lucrative for lenders (though they are not risk-free by any means).

For example, the DIP facility in this case is subject to an interest rate of SOFR plus 12% with a SOFR floor of 3% (or Base Rate + 11%), a 10% fee on the new money portion, and another 6% fee on the new money at exit if the lenders do not acquire the assets of VICE through a credit bid (translation: new buyer swoops in for the rescue). That means the DIP lenders could earn up to $6.1mm in 6 months on their $10mm new money investment.

VICE received access to a $60mm DIP facility, of which only $10mm was “new money” (new cash extended to the company). The remaining $50mm was a roll-up of pre-petition senior secured term loans. In essence, most of the DIP was the term loan lenders taking previous debt and exchanging it into the DIP. This DIP facility came from Fortress, Soros Fund Management, and Monroe Capital. All three lenders were lenders of the Term Loans in 2019.

The Cap Stack

No bankruptcy is complete without a look at the cap stack.

VICE had $834mm in funded debt before bankruptcy (“pre-petition”), received $10mm in new money from the DIP, and the term loan / DIP lenders are credit bidding for $225mm.

Here’s a visual illustration:

• DIP Facility: Term Loan lenders provided a $60mm as a DIP facility post-petition.

• Term Loans: $250mm initial term loans + $57mm 2023 term loans + PIK Interest

• Overdraft Facility: Overdraft facility with JP Morgan

• The Pulse Notes: $21mm in loans owed to the founders of Pulse resulting from their sale to VICE, secured by shares in Pulse Films. Subordinated to the Term Loans

• Senior Subordinated Notes: Unsecured debt owed to TPG and Sixth Street

What Happens to VICE?

Following the conclusion of the bidding process a final buyer will close the deal. Given the extensive sale process conducted over the last year for VICE, it’s unlikely for a new buyer to emerge at this stage. VICE will be handed over to the lenders who are credit bidding $225mm.

If VICE can find a way to turn things around it will sputter on as a smaller company with a more manageable capital structure. If not, the lenders-turned-owners will try to capture as much of the asset value as they can.

The sale process is scheduled to conclude by July 7, 2023.

Bye for now!

Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

Restarting a business with hundreds of thousands of employees and many millions of passengers a year is a monumental task. Now, with operations having returned to normal and bookings surging, Carnival must focus on increasing cash flow to manage its debt burden without having to tap the capital markets again.

Failure comes with a huge cost. Putting Carnival through a bankruptcy process would require handing an otherwise profitable company over to lenders.

The company’s debt burden combined with consistently missed expectations (including a 14% revenue miss in Q3 2022) hurt the market’s confidence in Carnival’s ability to recover. Carnival’s Q1 2023 performance and recent strength among competing cruise liners Royal and Norwegian have improved sentiment, but CCL has a long road to recovery.

With negative LTM EBITDA, $36B in debt, and $9B of maturities through 2025, Carnival has a crucial year ahead. It’s sink or swim for the world’s largest cruise company.

The Situation

Carnival had a banner year in 2019, generating $21B in revenue and $5.5B in adjusted EBITDA.

From early 2020 onwards, global travel restrictions, social distancing measures, and public health concerns brought the cruise industry to a standstill. Faced with an impossible situation, Carnival experienced massive losses in revenue and mounting operational costs.

To stay afloat, Carnival took several measures, including:

1. Raising capital: FY2020 - 2022, Carnival raised over $5.4B through equity raises and over $23B in debt to increase its cash reserves and shore up liquidity.

2. Cost reduction: Carnival implemented cost-saving measures such as taking the fleet out of service, laying off employees, reducing marketing expenses, and deferring capital expenditures. Despite these measures, the company has significant fixed costs that could not be avoided during the halt.

3. Selling assets: Carnival generated ~$750mm in proceeds from selling ships in FY2020 - 2022 to reduce costs and streamline its fleet.

4. Reduce order book: In an effort to manage its debt burden Carnival is scaling back its ship orders, expecting 4 ships through 2025, no ships in 2026, and “just one or two new builds each year for several years thereafter” per management.

Q1 2023 Results

Carnival is showing early signs of a turnaround. The company experienced its highest booking quarter in history. Higher volumes from travel agents has driven a higher percentage of new-to-cruise customers — customers Carnival hopes to retain.

99% of Carnival’s fleet was back to service by Q4 2022. Bookings in Q1 2023 were at 95% of Q1 2019 levels. Management stated that debt has peaked, and they do not expect to raise additional equity this year. They expect to be able to pay down upcoming maturities with excess liquidity (consisting of $5.5B in cash and $2.6B in availability under their revolving credit facility).

But.

Even if Carnival can return to its pre-COVID glory as a cruise liner, its cap stack needs to be addressed. The company’s debt increased from $11.5B at the end of FY2019 to ~$36B today.

The Cap Stack

Carnival will face ~$9B of debt maturities from Q2 2023 through the end of 2025 and nearly $6B in interest over this period (ouch).

At its current effective interest rates, Carnival can expect to pay ~$2.1B annually in interest. For every $1B in debt repayment, Carnival can save ~$60mm - $100mm in interest.

If Carnival can breakeven on a free cash flow basis they can start to use their excess liquidity to paydown debt. The company currently has $8.1B in liquidity and a minimum liquidity covenant of $1.5B. Paying down ~$6B of debt can save $300-$600mm per year in interest payments but risks exhausting liquidity without being in the clear operationally. Carnival will have to be strategic about when early repayments are made, and may be better served by making the interest payments and looking to refinance its most expensive debt when possible.

Q1 2023 revenue is nearing 2019/2020 levels, and management’s adjusted EBITDA guidance for 2023 is $3.9B - $4.1B.

Compared to 2019, Carnival has higher fuel costs, inflationary pressures, higher interest rates, and higher debt obligations. Fuel costs in particular have increased significantly, representing 12% of revenue in Q1 2023 compared to 8% in Q1 2019.

To meet debt obligations, not only will Carnival need to restore its booking volumes to at least its 2019 numbers, the company will need to pass cost increases on to consumers through higher prices.

Management’s 2023 expectations are based on stabilized fuel and inflation pressures and assumes bookings are at 2019 levels by Summer 2023. Recent earnings reports from competitors indicate bookings may exceed this pace.

Liquidity

Through 2025, Cap Stack estimates that Carnival will need to make ~$21.5B in cash payments towards interest, mandatory debt repayments, and capex, net of drawings on export credit facilities. Carnival has $5.5B in cash on hand and $2.6B in availability under its RCF, but must maintain $1.5B of that to comply with covenants. If Carnival burns through all its excess liquidity, the company will still need to generate ~$15B in Adj. EBITDA over the next 3 years.

Is this reasonable? If we assume management hits their $4B EBITDA target for 2023, recovers to 2019 EBITDA of $5.5B for FY2024, and increases EBITDA by 10% for FY2025 to $6B, Carnival can make it through. If we assumed a flat $5.5B for 2024 onward, Carnival would run out of cash by 2027 barring additional capital raises. These cases assume Carnival’s secured debt is refinanced as it comes due.

Carnival should be able to easily refinance $2.6B in 1L debt coming due in FY2025. Past 2025, Carnival’s survival will be contingent on its ability to repay or refinance some portion of the debt coming due in 2026 and 2027. Given where Carnival’s bonds are trading, the market’s view is that the company can skate by.

Carnival does not have much headroom under its coverage ratios but should be able to amend / get a waiver as it turns things around.

The net book value of Carnival’s ships is $37B, of which ~$30B is pledged as collateral to secured debt.

All in all, as long as Carnival can execute this turnaround, the cap stack can be managed with a few more years of pain.

The Business

Carnival generates the overwhelming majority of its revenue in two ways:

• Passenger tickets

• Onboarding spending

Historically, tickets make up ~60-65% of total revenue and onboard expenses make up most of the rest.

Cruises have evolved over the years from being all-inclusive packages to including a variety of onboard activities and stores including spas, art auctions, casinos, cybercafes and more. Cruise operators also sell excursions and local tours for the destinations they travel through.

The cruise industry experiences seasonality. “Wave” season in Q1 of every year is when cruise companies run their biggest marketing promotions and discounts (these “discounts” are typically built into prices already). The highest demand is typically in Q3, and Carnival’s highest share of operating income typically comes in this quarter.

The cruise business has high capital expenditures and high fixed costs. These create high barriers to entry, and over the years have driven consolidation in the industry. The three largest players (Carnival, Royal, Norwegian) control over 70% of the market. MSC Cruises is 4th place, with ~6% market share.

Fuel costs are one of Carnival’s largest expenses and have been rising in recent years. That said, Carnival generally has a good idea of how much fuel is used in each trip and can optimize ticket pricing and destinations to improve profitability. All they have to do is achieve high occupancy for their trips! Easy enough, right?

Cruises have a unique value proposition relative to land vacations. Cruises provide a more exotic experience with a better bang-for-your-buck. Compared to destination vacations, cruises are often cheaper. It’s no wonder the cruise industry had an annual passenger CAGR of 6.6% from 1990 - 2019.

Is Carnival the elusive “good business, bad balance sheet” distressed investors have been looking for?

Cap Stack’s View

Carnival is a highly levered, industry leading cruise liner in the midst of executing an ambitious turnaround. Buoyed by pent up demand in travel, Carnival has seen record bookings even compared to its pre-COVID levels. Its largest future capital needs (debt repayment and CapEx) have a high degree of visibility. Fuel costs and other inputs have increased, but the company has good internal visibility on its occupancy needs to cover these costs and generate profit. A record booking season and outperformance in recent earnings from competitors is encouraging.

Carnival has at least 3-4 years of liquidity runway to correct course, assuming management can meet EBITDA expectations for 2023 and meet or exceed 2019 levels in 2024. Leveraging unencumbered assets, refinancing secured debt, and strategically paying down debt to reduce interest burden can extend Carnival’s turnaround runway to 5+ years.

Recent earnings reports from competitors have been encouraging, meaning Q2 and Q3 for Carnival are likely to exhibit strong performance. In the years to come, Carnival will need to grow into its new capital structure by achieving high occupancy rates and growing revenue per customer.

In any case, the worst has passed for Carnival (can’t exactly get worse than being shutdown for over a year).

Will Carnival go bankrupt? Cap Stack’s view is… probably not. A severe economic downturn would change our opinion, but Carnival can likely survive through a mild recession given its liquidity position.

In fact, Carnival could be one of the turnarounds of the century.

At 2019 EBITDA levels and a 12x valuation (similar to pre-COVID), the implied share price would be ~$28 assuming no debt paydown (rough estimates).

The future of Carnival has huge execution risk as a result of high leverage that came out of an impossible situation outside of the company’s control. This turnaround would certainly be up there with the G.O.A.Ts.

Appendix: Historical Financials

Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

This post expands on the differences between typical bankruptcies and FDIC receiverships. The FDIC has a lot of authority when it comes to bank failures, including putting a bank into receivership in the first place. Critics have stated that a Chapter 11 process would result in more prudent risk management and oversight from lenders and investors. The counterargument is that bank failures, especially large ones, are a high stakes deathmatch. We lay out the differences for you to decide and give our opinion at the end.

The next edition of Cap Stack will cover another stressed/distressed situation. We covered Redfin last week — check it out if you missed it. If there are specific distressed investing topics you’re interested in learning more about email us back or drop us a comment and we’ll be happy to cover them.

In the mean time if you know anyone who would find Cap Stack valuable, send them our way.

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— Cap Stack Team

The Federal Deposit Insurance Corporation (FDIC) was established in 1933 to stabilize the U.S. banking sector in the midst of The Great Depression. In addition to its role as an insurer and regulator of banks, the FDIC has special powers to manage bank failures through conservatorships and receiverships.

In the U.S., banks cannot file for bankruptcy protection the way non-bank companies can. Chapter 11 is not applicable for bank entities. An FDIC seizure of a bank may appear similar to a bankruptcy process and does have many of the same rules, but there are major differences. The FDIC along with the bank’s primary regulator makes the determination for when a bank has failed. The FDIC has the power to remove and replace a bank’s management and board of directors as well as eliminate shareholders’ rights.

Creditors in bankruptcies can influence, vote on, or object to decisions. In an FDIC receivership, creditors do not have this ability.

The FDIC puts failed banks into receiverships to effectuate a sale to another institution (identified in advance, where possible). An acquiring bank will assume the failed bank’s deposits and potentially some other liabilities. The FDIC may look to provide sweeteners to these deals to incentivize acquirers who may be plugging their nose when assuming these liabilities. The failed bank’s assets are sold off as part of the sale or by the FDIC in a process that may take months or years.

Traditional bankruptcies require the approval of creditors. Even a “cramdown” requires some creditors on board, and creditors can appeal to the bankruptcy judge.

In a bank receivership, the FDIC swoops in like G.I. Joes, seizes the bank, and aims to make insured deposits available within two business days. The FDIC might seize a bank on a Friday and have it reopen on Monday as part of a new bank. This sort of speed is unheard of in traditional bankruptcies, and is only possible because of the power awarded to the FDIC as a government agency.

With great power comes great responsibility, as they say. The FDIC markets failed banks to healthy banks. Its goal is to maintain financial system stability and public confidence. The FDIC is also required to resolve bank failures using the least costly resolution to minimize losses to the Deposit Insurance Fund (DIF). The DIF is is funded by pooled fees from U.S. banks. If the DIF is insufficient the FDIC can borrow from the Treasury and pay it back through future assessments on banks.

Non-depositor creditors and shareholders are of lower priority. Depositors have statutory priorities over other unsecured claims. The FDIC will optimize for making depositors whole.

Under the Federal Deposit Insurance Act (FDI Act), the priority of proceeds are:

1. Secured claims

2. Admin expenses of the receiver

3. Insured deposits

4. Uninsured deposits

5. Other general or senior liabilities

6. Subordinated obligations

7. Shareholder claims

The practical implication here is that after deposits, other claimants do not receive much if any recovery.

Insured depositors are paid in full “as soon as possible”, while uninsured depositors are subordinated in priority and may need to wait.

Bank failures can be a highly political situation. Government officials have gone out of their way in to point out that shareholders and debtholders of failed banks are not being protected by the government. The FDIC’s mandate for a least-cost resolution amplifies this effect, calling for the FDIC not to take actions that increase losses to the DIF to protect non-depositor creditors. The FDIC resolution must be the lowest total expected FDIC expenditure. Exceptions could be made, but only for systemically important institutions.

Depositors are, rightfully so, the last to take a loss. Shareholders and debtholders are sophisticated players who are putting on risk when extending capital to a company. Depositors on the other hand cannot be reasonably expected to become financial institution experts (although some prudence in where funds are deposited should be encouraged).

You need not look far back in history for examples of creditors getting torched in highly politicized situations. The Detroit, Puerto Rico, and Chrysler bankruptcies are just a small handful of examples.

Despite having capital at risk, recent bank failures went largely unnoticed by many investors until it was too late. First Republic Bank (FRC) was underwater on its equity based on the company’s own reported fair value measurements as early as Q2 2022. With the last banking crisis having been over a decade prior to today and years having gone by with any bank failure at all, many market participants misjudged the extent to which larger banks were at risk.

Bank Holding Companies

Bank entities go through the FDIC receivership process but non-bank entities are still awarded bankruptcy protections. That’s why SVB Financial Group ended up in Chapter 11 even after SVB’s receivership.

That does not mean a bank holding company is free from all obligations. The FDIC is awarded advantages per Section 365(o) of the bankruptcy code. You see, bank entities have to maintain minimum capital ratios (CET1, Tier 1, etc.) per regulations. If a bank holding company enhances its own financial position at the expense of the bank subsidiary’s capital, taxpayers become the bagholders. The ultimate obligation is a contentious point that can be litigated, but when it applies the holding company must satisfy its obligations or be forced to convert to Chapter 7 and liquidate.

Receivership Process at a Glance

The FDIC receivership process involves:

• Marketing the failed institution

• Closing the failed institution

• Repayment or assumption of insured deposits

• Minimizing costs to the DIF (thereby requiring maximal recovery value based on cost, timing and risk)

The FDIC tries to enter a purchase and assumption transaction before a bank is put into receivership. This transaction involves a healthy bank purchasing the assets of the failed bank and assuming at least the insured deposit liabilities.

As many assets are sold as quickly as possible and distributions are made to creditors (the largest of whom are depositors). Assets that remain are continued to be marketed after the receivership.

The FDIC has the power to transfer any asset of the failed bank without approval or consent. The FDIC in essence acts as both the trustee and bankruptcy judge.

Cap Stack’s opinion is FDIC receivership is better for depositors than a Chapter 11 process would be due to the speed with which the FDIC is able to act and the cost savings (bankruptcies are expensive!). For basically every other constituent including stakeholders of non-bank entities, receivership will probably result in a bad outcome.

Everyone loses money, including the FDIC (taxpayers)! Except Jamie Dimon over at J.P. Morgan — he swoops and picks up the good parts.

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Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

Even seasoned management teams can find themselves caught off guard in the froth of a zero interest rate bull market. Worsening macro conditions, high operating expenses, and a fiercely competitive real estate market might just be enough to send Redfin hurtling over the edge.

The stock has collapsed, falling a whopping 91% from its peak February 2021.

The Business

Redfin is a residential real estate brokerage that employs its own real estate agents. As a digital-first business, customers discover Redfin through the company’s website and mobile app where they can browse listings and book tours with Redfin agents.

Redfin differentiates itself from traditional real estate brokerages in a few key ways:

• Discounted 1.5% listing fee vs. 2.5-3% for realtors

• Realtors manage the entire process whereas Redfin has staff other than agents managing parts of the process (marketing, open houses, documentation, etc.)

• Redfin agents are employees and earn salaries, benefits and a flat rate whereas realtors get paid entirely on commission

Redfin’s long-term goal is to act as an end-to-end solution for real estate services including buying, selling, and renting homes, receiving mortgages, and title services. They compete by being cheaper, faster, and providing a superior digital experience compared to traditional brokerages.

The Situation

Adjusted EBITDA was -$192mm for 2022. After capex and cash interest, that comes out to $234mm cash flow burn — roughly the same as the amount of cash Redfin had on hand at the end of 2022.

Gross profit margin is down from 26% in 2020 to 13% in 2022. Despite a $1.4B revenue increase over this period, Redfin only generated an incremental $54mm in gross profit.

Q4 2022 revenue fell 25% y-o-y to $480 million and gross profit fell 65% to a mere $37 million.

With the hopes of keeping the lights on, Redfin is making some changes.

Will it be enough?

Just a few days ago, Redfin announced its third round of layoffs in a year, adding another 200 bodies to the 1300+ employees laid off in 2022. The company still has over 5,300 employees.

Redfin agents are employees that receive salaries and benefits. These agents are paid regardless of whether or not agents close deals. Collapsing transaction volumes makes Redfin worse off than traditional brokerages.

Redfin also shuttered RedfinNow, an instant buyer of real estate. The winddown began November 2022 and liquidation will be completed in Q2 2023.

Suffice to say, things are bad. Typically these “turnaround stories” come with some sort of overly ambitious operational restructuring plan that bakes in a gazillion dollars in cost savings into the forecast.

For Redfin, the plan seems to be layoff employees, shutter unprofitable divisions and hope the market recovers.

That’s a bold move Cotton. Let’s see if it pays off.

The Cap Stack

Redfin has $1.1B in unsecured senior convertible notes outstanding with a total market value of $767mm. Given where the 2025 and 2027 notes are trading, the market is implying there’s stress, but not necessarily distress. The consensus expectation is that there will be bumps in the road but Redfin should be able to deal with upcoming maturities.

Subsidiary Bay Equity has $191mm in outstanding debt from warehouse credit facilities. These facilities have a combined total of $550mm in borrowing capacity.

Bay Equity is Redfin’s mortgage business. The business uses warehouse credit facilities to fund originations then sells the mortgage business in the secondary market to paydown the facilities. It’s a relatively new business for Redfin, acquired in April 2022 for $138mm.

Redfin also paid $608 million to acquire a company called “RentPath” in April 2021 for rental searches. This includes ApartmentGuide.com, Rent.com and Rentals.com. The rentals segment earns revenue primarily through subscription offerings for listing services.

The properties segment consists of revenue Redfin earns from the sale of homes bought from sellers on the platform (RedfinNow).

Debt Maturities

Redfin’s house is on fire, but the company doesn’t have a large maturity until the October 2025 maturity of convertible notes. They should be able to extinguish the $24mm due in July 2023 without a sweat.

There’s also $40mm in preferred equity that has to be repaid in Q4 2024. The holder can elect to receive payment in Redfin common stock, cash, or a combination.

Without a substantial improvement in the prospects of its core business Redfin will not be able to refi or otherwise manage its 2025 converts repayment. The company will be forced to find a solution with lenders.

A lot can change in two years, however. What about before then?

Redfin had $240mm in unrestricted cash and $152mm in short-term investments at the end of 2022. These investments consist of cash in financial institutions, money market instruments, U.S. treasuries and agency bonds. We’re comfortable including these investments as part of Redfin’s liquidity.

That brings us to $392mm in total liquidity.

Here’s a quick n’ dirty back of the envelope estimate for 2023 liquidity if we assume the same cash flow from 2022.

Not the worst we’ve seen. Based on 2022 cash flows, Redfin has ~19 months of runway net of the 2023 notes. The 2025 and 2027 notes have low interest rates, so their drag on liquidity is minimal until they mature. Redfin has been buying back and retiring debt, including $142.5mm of the 2025 notes in Q4 2022.

Here’s the thing: 2023 Redfin is going to look a lot different from 2022 (except for the part where they burn tons of cash).

Management expects an adjusted EBITDA loss of $84mm to $73mm in Q1 2023, compared to $49mm in Q1 2022.

The upside down hockey stick chart is taking shape. Redfin and its shareholders will have to hope this stick gets knocked upright to stand a chance.

Unfortunately for them, 1H23 volumes are likely to be stronger than the second half from a seasonality perspective. Considering that another 200 employees were laid off in April, Q2 probably isn’t going so well.

Even if the market were to stabilize, Redfin’s business is unlikely to turnaround quickly enough. There are issues inherent to the business model. Redfin provides a discounted service with a cost structure that’s worse than competitors.

The company boasts that Redfin agents get paid 2x the median income of agents at comparable brokerages. They need to heavily maintain marketing spend to grow market share in competitive markets. These factors combined are why Redfin’s operating margins per agent, even during periods of high transaction volumes, are sub-10%.

Sidenote: Redfin Agents vs. Realtors

Full service agents only eat what they kill — no sale, no commission. Commissions also mean full service agents will get paid more for higher sale prices, whereas Redfin agents earn a flat fee. If you’re a top producing real estate agent, you will outperform by working on commission. If you’re a rookie without an existing client base, you will likely earn more at Redfin. The heaviest hitters in a locality aren’t working for Redfin.

That doesn’t mean Redfin is an entirely poor choice for buyers and sellers. Redfin’s lower-cost solution is better suited for certain customers. The company’s listing data, quality search experience and high web traffic serves as a valuable source of leads that can be converted to clients.

Redfin also refers listings to third-party brokers who pay 30% of their commission fee to Redfin. Naturally, this is a much higher margin business.

Saving Grace

Redfin has ~$115mm of home inventory, of which $97mm is slated to be sold as part of the ongoing RedfinNow winddown. The sale of this inventory, even if completed at discounted prices, will give Redfin additional runway to wait out the market storm and resolve operational issues.

Other possible avenues to extend runway would be monetizing other parts of the business, such as the acquisitions of Bay Equity and RentPath. Selling these businesses would allow Redfin to extend its runway further while it right sizes its cost structure. The company would realize a significant loss on these purchases but may be able to deal with its 2025 maturity.

Cap Stack Outlook

Redfin spent heavily on acquisitions to enter new businesses and hired aggressively during booming markets. Flush with a high stock valuation and easy access to capital, the company lacked cost discipline. Rising rates, persistent increases in cost of living, and an uncertain economic picture have resulted in a slower housing market. Due to its high personnel costs, marketing spend, and network overhead, Redfin is bleeding out. Fast.

If the market does stabilize, Redfin might be able to ride the struggle bus up until the 2025 notes near maturity.

The more likely outcome is that Redfin faces a liquidity crunch within 18-24 months.

The saving grace is that Redfin has $115mm of home inventory that will provide an inflow of cash and help extend the runway. Should they be willing and able, the company could monetize the two non-core businesses acquired in the last two years (taking a substantial loss) and buy more time. Otherwise, the company is heavily reliant on market conditions to dodge a bankruptcy filing.

It’s not all bad. Redfin has 50mm+ unique visitors to its site and a proven model for conversion. The real estate services business can be profitable, as past years have proven. But the Redfin business today has poor unit economics, losing money on every agent except in the hottest of real estate market conditions.

Despite a strong housing market in 2021 and record low rates, Redfin found a way to lose money. We anticipate Redfin’s treasured goal of growing market share will also lose steam as the impact of layoffs plays out over the course of 2023.

Is Redfin going bankrupt? The Cap Stack opinion is.. Probably.

With that, we will close out our Redfin report with the following parting words for the company: pls fix.

Appendix: Historical Financials

Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.

Corporate downfalls are a complex labyrinth. Even the most promising businesses can crumble in the face of unforeseen obstacles.

Thriving in these environments is challenging. Companies need to make large scale high-impact moves that often require a large amount of capital. To accelerate growth and beat the competition, capital is borrowed.

Effectively managing the capital structure is mission critical to a company’s success.

When mismanaged, companies meet an untimely demise and find themselves handing over the keys to their lenders. Over years of working in distressed situations, we’ve seen this story time and time again. Companies either get ahead of themselves or fall behind their competitors. Sometimes industries change, and companies fail to adapt. In other cases, their industry faces disruption to such an extent that adapting is impossible.

As we explore the mind-bending, knife-fighting world of corporate failure, you'll be equipped with valuable insights to help you identify risks and make more informed decisions. At minimum, getting a glimpse inside this secretive world will sure as hell be entertaining.

Join us at Cap Stack as we delve deep into the heart of financial missteps, uncovering the pivotal role that corporate capital structures play in the success or downfall of a company.

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Why Companies Fail

A leveraged buyout (“LBO”) is the acquisition of a company where most of the purchase is financed by debt.

The acquirer, generally a “private equity” fund, will put up the equity portion of the deal and take loans from a range of lenders to finance the rest.

A birds eye view of the private equity playbook is:

• Identify and acquire undervalued companies

• Use debt to pay for most (50-75%) of the purchase

• Increase profitability through cost-cutting and operational improvements

• Optimize the capital structure

• Exit through a sale or IPO

Private equity funds use far less leverage today than they used to, with average Loan-to-Values closer to 50% compared to nearly 70% in 2005.

2005 was a big year for LBOs. In the years following the dot com crash, the value of LBO transactions soared, reaching $130B in 2005 at an average multiple of 8.1x EBITDA. A number of private equity buyers turned their eyes to everyone’s favorite toy store - Toys “R” Us (“Toys”). A consortium of funds consisting of Bain Capital, KKR and Vornado Realty Trust (a REIT) bought Toys in a $6.6B LBO. 80%, or roughly $5.3B, was financed by debt. The funds were interested in Toys’ real estate assets as well as the prospect of expanding to Asia.

12 years later, on September 8th, 2017, Toys filed for Chapter 11 bankruptcy. Those outside the world of distressed companies were appalled. How could the beloved store they had shopped at as a kid go out of business?

Problems with Toys

Well, maybe they weren’t that appalled. Competition was fierce in the toy industry and customers had cheaper options. Big box retailers like Walmart were willing to use toys as loss leaders and make up the margin by selling other products in-store.

The ecommerce trend had been accelerating and Amazon was experiencing massive growth. Toys’ online business on the other hand was lackluster and uncompetitive. They were doing too little, too late.

Over the years Toys had been unable to shed its massive debt. Leverage is both a double-edged sword. By investing a tiny sliver of equity, you can increase your return on cash. The flipside is that highly levered companies have large interest burden — over $400mm a year in the case of Toys. Too much cash flow going towards interest increases financial risk and makes reinvesting in the business difficult.

When companies are performing poorly, it can become difficult to attract and retain executive talent. If performance bonuses are deeply out of the money and the writing is on the wall for the company, employees may start to look elsewhere. The relationship the CEO has with the private equity owners may start to break down. Mismanagement and turnover were not doing Toys any favors.

By Q4 2017, the company operated 1,639 stores including 926 traditional Toys “R” Us Stores, 234 Babies “R” Us stores and 479 outlet/express stores. Toys also licensed 267 stores internationally. The business was global, complex, and slowly bleeding out financially.

Toys’ issues came to a boiling point following a news report stating that Toys was considering a potential bankruptcy. This report spooked vendors, and a collapse in trade resulted in the Company filing for free-fall bankruptcy.

When vendors lose confidence in a buyer’s ability to pay they may ask for tighter payment terms. Whereas a healthy company may have 90 days to pay, a company rumored to be on the brink of bankruptcy could have to pay cash upfront in-full.

With limited liquidity on hand and an already strained financial position, Toys cratered.

Why did Toys fail?

• Years of mismanagement led to an uncompetitive business

• Debt burden resulted in high cash burn

• Vendors lost confidence in Toys’ ability to pay

• Toys did not adapt to secular industry trends early enough

The Toys failure is a masterclass in the world of busted LBOs, corporate downfalls and expensive bankruptcy proceedings. Toys was an international business with a complicated organizational structure, multiple competing creditor constituents and billions of dollars at stake.

The dynamics of the bankruptcy will make for a fascinating story in a future Cap Stack post. Here’s a teaser:

Final Takeaways

Private equity funds do not hold on to their investments forever. The holding period is typically between three and five years, after which they look to exit their position.

When a fund holds on to a portfolio for longer than normal (especially over a decade!), it usually means the fund is unable to exit at favorable returns for one reason or another. Perhaps the broader market is weak, the industry has fallen out of favor, prospective buyers aren’t interested, or the company has fallen apart under their ownership.

While it’s seductive to believe that private equity firms were the sole drivers of the downfall of Toys, the business they purchased in 2005 was already facing challenges. There were multiple missteps along the way dating as far back as the early 2000s when Toys made the grave mistake of allowing Amazon to handle fulfillment. This undoubtedly served as a boon for Amazon who played a huge role in taking them out almost two decades later.

It’s a wonder that Toys chugged along for as long as it did.

Some might like us to believe that Toys never needed to file for bankruptcy at all. Had an article speculating about their demise never been published, trade terms wouldn’t have been yanked, and Toys could’ve hidden its problems in perpetuity. We’re not convinced, but it’s a cute story.

As we’ll explore more deeply in future posts, the world of bankruptcies has many wonderful storytellers. Especially when there are bills to be paid.

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Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions.