Weak Bonds

Private Equity's Retail Debt Carnage

Business is bad, covenants are weak and assets are walled off.

Not all poorly performing retail bonds are created equal. 

The worst of the bunch have a shared feature: They're all backed by private-equity companies.

Take Neiman Marcus, which carries nearly $5 billion in debt. Owned by Ares Management and the Canada Pension Plan Investment Board, the struggling department-store chain said this week it planned to hire bankers to explore selling itself or its assets. It also said it had carved out what analysts estimate are about $500 million worth of assets into a separate subsidiary, out of bondholders' reach, diluting lender collateral. 

Meanwhile, there were reports that competitor Hudson's Bay Co. wants to buy the company, but leave the debt behind. (More on that later.) 

So far this year, Neiman Marcus bonds have returned negative 19 percent, the worst performance among the top 50 issuers in the Bank of America Merrill Lynch U.S. High Yield Index. (The index, the ticker for which is, aptly, "HURT," also includes some of the worst-performing bonds in the high-yield market.) 

Loss Leaders

Debt of PE-backed retailers has plunged more than those of non-PE owned peers

Source: Top 50 Issuers in the Bank of America Merrill Lynch US High Yield Retail Index

But Neiman Marcus isn't an isolated case.

Retailers backed by private equity dominate the list of most-distressed U.S. store operators. Investors are demanding massive premiums to own their debt, implying they're more likely to default than their peers. And yields on this debt have only risen this year, even though junk bonds generally have performed well in 2017.

Great Divergence

While U.S. junk-bond yields have fallen, yields on junk-rated retail debt have risen

Source: Bank of America Merrill Lynch index data

The list of retailers in this category is painful to look at, full of cringe-worthy stores, located in downtrodden malls, such as Claire's, Hot Topic and Rue 21.

Risky Business

Bonds of retailers backed by private-equity are yielding four times as much as their peers without PE money

Source: BOFAML US High Yield Retail Index

These retailers may not even exist in any recognizable form three to five years from now. But as they hobble along, it's all too apparent the companies are taking actions to help their PE owners mitigate their losses. And that can be bad news for some bond investors.

Take J. Crew, which finagled a way to insulate valuable intellectual property (think: trademarks, web domains, etc.) from creditors by transferring the assets into a separate subsidiary. The company (and its PE sponsors) could later use those assets as collateral to raise additional debt or otherwise unlock value from the retail chain.

Ditto for Neiman Marcus if bought by Hudson's Bay, which would likely find a way to finance a deal by selling assets such as stores, leases, brands, or even the vaunted Bergdorf Goodman flagship, in a way that could pad the pockets of Neiman's private-equity backers while hurting some bondholders. 

Neiman Marcus and many of these PE-backed retailers were troubled to begin with, so it's fair to wonder what came first, the bad business model or the vulture investors. What we do know is that bonds of PE-owned retailers are performing worse than those of their solo peers. These retailers also have more debt relative to income than other store operators. And these chains seem to be more likely to have crafted loose bond covenants, giving the owners flexibility to do things like sell valuable assets without repaying certain bondholders.

In an interview with Bloomberg Radio Thursday, Citigroup analyst Jenna Giannelli pointed out PE firms haven't taken a lot of money out of these retailers yet and are doing everything they can to stave off bankruptcy in order to protect their equity. She said bond investors should be concerned about weak bond covenants giving the companies "flexibility to move assets out, to the detriment of the creditors." 

To be clear, these PE firms have a fiduciary responsibility to make money for their clients, even if that means stiffing some bondholders. Some debt investors brought pain on themselves by overlooking weak covenants in their zest for higher-yielding securities.

But at this point, there's a reason these notes yield so much more than even those of other retailers. Investors should think twice before considering the debt a bargain. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the authors of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net
    Shelly Banjo in New York at sbanjo@bloomberg.net

    To contact the editor responsible for this story:
    Mark Gongloff at mgongloff1@bloomberg.net

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