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Chris Haffenden

The small print often says that past performance is no guarantee of future performance. We see this language oft used to caveat to investors that any current outperformance may not continue. 

The borrowers’ past was imperfect with a lead manager now pitching future perfect to tense investors concerned about past aberrations.

This came to mind this week for a couple of new LevFin issues, Pepco and Burford Capital. 

They have little in common as businesses, apart from coming under heavy bombardment from short sellers in the past five years. There was fire behind the smoke for Pepco’s ultimate owner Steinhoff as Viceroy’s revelations uncovered a massive fraud and led to a debt restructuring in 2019, with a secondary sale process now very live; but while there was a lot of white heat surrounding Muddy Waters’ attack on the litigation funder Burford Capital in 2019, of late there has been an uneasy truce between the two parties as Burford has posted impressive numbers.

For those looking at the two new issues with a fresh lens, there could be an opportunity. As with a few transactions this year such as Travelodge and Benteler their imperfect past could lead to better and higher yield entry points compared to their ratings, and improved net future values. 

You can see this in the pricing. The Ba3/BB rated Pepco was upsized to €375m and priced at 7.25%, from high 7s IPTs, whereas Burford’s (Ba2 rated) $400m 2031 senior notes priced at 9.5% yield.

So, could it be better own a primary deal with Hairy Issue Premium (HIP) rather than one with a new issue premium (NIP)? Let us know your thoughts. 

Other phrases that entered and reentered the finance vernacular this week, were “Hawkish Pauses” and “The Sick Man of Europe”. Jerome Powell talked tough about higher for longer but still paused hikes; while the UK further economically diverged from the rest of Europe this week, but not in a good way! 

The latest rise in UK rates and jump in gilt yields comes at a bad time for many stressed EHY sterling borrowers. Earlier this week, we published (Not So) Blessed to be Stressed — Sterling job required for 2025 maturities – looking at TalkTalk, Iceland and Stonegate Pubs. 

At time of writing, we await news of EG Group’s A&E (commits were supposed to be Wednesday) — with some investors asking just How much gas is left in EG’s tank?

As a young Aussie Eurobond market maker in the early 90s, every Xmas I used to participate in a game with other market traders where we would make markets in random items, where we had little visibility in values. My favourite year was our trading in Camels. For fun and entertainment I tried to physically deliver a dromedary to Neil at Samuel Montagu (HSBC) — borrowed from Whipsnade Zoo, with keeper — but unfortunately, I was unable to process the paperwork in time.

I was more successful (or at least on paper) from the trading in the next festive season when we switched to lemons, having managed to amass a long position of around 5,000 lemons cheaply. But the problem was delivery. I received 7,000 lemons via black cab one afternoon at Barclays Towers, having to hastily negotiate space in the post room to store, while I offloaded. 

Luckily, Victor, manager of El Vino’s The Old Wine Shades, just across Lower Thames Street, where most of us hung out after hours, had bought 4,000 from me, and while a faff, it wasn’t too far to carry. But unfortunately many of the lemons had gone around the market for weeks and were now going off, leading to Victor ceremonially banning me for life from Barclays’ de facto Social Club.

As a footnote, I returned there 20 years later as a journalist. The place had hardly changed, apart from a new snug named after Victor — I was please to hear he was still alive, retired, but he popped in every now and again — and my name wasn’t on the banned list behind the bar!

During my short stint trading citrus fruit, one of the more cerebral traders (yes, some were well read and educated, not just barrow boys) pointed out the George Akerlof paper "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism." 

The TLDR of his paper is that the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, which ultimately leaves goods that are found to be defective after purchase in the market — very apt in my experience above. 

I was reminded of this when doing my research into Burford Capital’s accounting methods and areas of dispute with Muddy Waters in their 2019 report. There is an excellent piece of research on third-party litigation finance by Robert F. Weber of Georgia State University in The FinReg Blog looking at how these companies finance themselves and challenges for investors in gaining information. 

Litigation Finance Companies are confronted by the Market for Lemons Problem, says Weber:

“investors struggle to discern honest LFCs using conservative valuation models from LFCs using unrealistic, opportunistic valuation models, and therefore assume everyone is dishonest.”

So what is the issue with litigation funders? Weber’s intro summaries the problem perfectly:

Imagine a company that invests in a portfolio of long-term financial assets. This company’s asset portfolio is, relative to the asset management industry, highly concentrated — a circumstance which naturally heightens the appetite of the company’s own investors to know more details of the assets in the portfolio. The company operates in an adolescent industry, and neither the company nor any of its competitors can yet point to an established track record of generating consistent returns on invested capital. This lack of historic performance data combines with the long duration of the company’s assets to increase portfolio uncertainty. The company’s investors can look only to the short-term history of a concentrated portfolio of longer-term financial assets.

Further, imagine that the company cannot tell its investors anything meaningful about any of its most important portfolio assets — even those positions that comprise, say, a full quarter of the company’s balance sheet! In fact, to disclose information about the assets would, in a curious dilemma, chip away at the value of those assets. Separately, to do so might even subject the people responsible for realizing the value of the assets to professional sanctions. As if that were not enough opacity, now imagine that the applicable accounting rules for this company require management to value their assets according to the results of internal proprietary valuation models. Hence, management marks the company’s assets to its own models, reporting any increase as earnings. Oh, and these models also must never be disclosed to investors. In light of all this opacity, a mere rumour about the integrity of the company’s accounting can cause single-day losses of 70 percent to stock investors, and 30 percent for bond investors [referring to what happened to Burford Capital in August 2019].

I remember plenty of long conversations with former colleagues in 2019 about the Muddy Waters (MW) report, and Burford’s unsuccessful lawsuit to force the London Stock Exchange to release its records on MW’s trades.

So how does Burford Capital account for the carrying value of acquired litigation claims?

There is a good explanation in the FY 22 results presentation — I’m giving away the punchline as after conversations with the SEC, they are adjusting their probabilistic models — to an output “tied more closely to our fair value process that will become available during the course of the upcoming months.”

So for a litigation asset which has expected outflows at the outset of say 100 and expected inflows (from realisation) of say 200 in three years time, they use the following calibration:

Over time Burford then makes adjustments to the fair value based on “observable case milestones” in subsequent periods — for example if you reduce the litigation risk premium by 50% (from 77 to 39) a year later this would result in the following:

Note that this would result in a reduction in revenue of around 12% compared to the prior model. 

It is also worth noting that recent sharp rises in interest rates will affect discount values and lower the NPVs for expected realisations. 

I think I’ve got my head around their accounting, but unless there are litigation situations whereby a privilege waiver is granted, as an investor you have to take it on trust that case milestones have occurred and that their marks are conservative. 

In litigation finance, there can be many losers (or much delayed gratification) before the occasional big winner lands, such in March with YPF, an oil and gas operator, which was nationalised by the Argentine Government. US District Judge Loretta Preska recently ruled that the Republic of Argentina is liable to YPF, reaping significant rewards for Burford — YPF-related assets have already led to $236m of realisations, more than 3x total capital employed, with more to come:

Pepco, the European discount retailer, which owns Poundland among others, is a simpler business to understand, and its price premium might be just guilt by association. 

To elaborate, its 73.2% shareholder is Dutch intermediate HoldCo Newco 3, created under the 2019 restructuring of Steinhoff Group to hold the non-African assets. 

Steinhoff, you say. Time to run a mile from this deal? 

Perhaps not. The OM for the new notes urges that it is ring-fenced from the rest of the group and is run separately, with no shared links or suppliers. There are no guarantees nor collateral being provided to Newco 3. 

That said, the timing of the bond issuance was strange, as it coincided with a court process in the Netherlands for a second stage restructuring under the WHOA process, which if was unsuccessful, SEAG lenders (at Newco 3) level could have enforced and taken control of the Double Dutch HoldCo which ultimately owns the Pepco shares.

Let’s fast forward to page 144 of the OM for more information:

“The SEAG 1/2 facilities are to be are expected to be refinanced, amended and/or extended contemporaneously with and conditional upon the restructuring plan implemented by SIHNV [ultimate owner] and its stakeholders pursuant to a Court 145 Confirmation of Extrajudicial Restructuring Plan (WHOA).” 

It goes on to give an update on the process:

“On June 1, 2023, SIHNV announced that the relevant stakeholders voted to approve the WHOA and that it had filed a request with the District Court of Amsterdam to confirm the WHOA. The District Court of Amsterdam held a confirmation hearing on June 15, 2023 and its decision is expected on or prior to June 22, 2023. Completion of the WHOA on the terms described above will not comprise a change of control under the terms of the Notes or the Senior Facilities Agreement, or trigger any rights of the holders of the Notes to require the Group to purchase their Notes or any mandatory repayment of the Senior Facilities Agreement.”

However, if the WHOA does not complete by 30 June, the majority of the Group Services debt would become due and payable. If Steinhoff cannot secure a further extension it cautions that one of its options would be to initiate insolvency proceedings. 

If the SEAG lenders enforced on their security, the OM states “it would not comprise a change of control” but it adds the lenders could seek to maximise their value by realising assets within Newco 3 including the sale of the shares in Pepco group. 

But they add: “For the avoidance of doubt, the shares in Pepco Group N.V. held by the Principal Shareholder are unencumbered so the SEAG 1/2L Facilities lenders would not be entitled to appoint a fixed charge receiver in respect of the shares.”

So in short, it seems there could be a change in legal owner of the Pepco shares, but little else. 

Effectively, from a covenant perspective, no credit support comes from the Pepco entity or its subs (i.e., the restricted group for the new bonds). 

And the change of control provision is almost bombproof from any events coming from above:

“In addition, Holders of the Notes will not be entitled to require the Issuer to purchase their Notes in certain circumstances involving (i) transfers to Permitted Holders (see “Relationship with the Steinhoff Group and Its Lenders—Steinhoff WHOA”); (ii) a SEAG Creditor Change of Control; or (iii) a significant change in the composition of the Parent Guarantor’s board of directors.”

In the end, the ownership change risk has proved irrelevant, or at last for the foreseeable future as the WHOA was approved by the Dutch court on 21 June. 

No hassle from the Steinhoff, but surely the leads could have a waited a week or two under the Dutch process had become clearer? Why the urgency?

An interesting aside, on Thursday a German Court issued an arrest warrant for Markus Jooste after the former Steinhoff CEO, and alleged mastermind behind the jumbo fraud, failed to appear at a hearing a couple of weeks earlier. It remains unclear whether South Africa will agree to his extradition. 

After a couple of failed attempts to trigger a CDS event for Groupe Casino, investors are placing bets on a July or October outcome after the French supermarket chain said it will ask financial creditors for a standstill on debt payments and a waiver of their rights should an event of default occur, as part of its conciliation proceedings.

“The conciliators will also ask the relevant creditors to waive any rights arising in the case of a potential breach of the 30 June and 30 September 2023 financial covenants under the Revolving Credit Facility, and more generally, to any event of default or cross-default event that may arise as a result of the suspension of the above-mentioned payments,” the company added.

As 9fin’s Dan Alderson writes: “This suggests a failure-to-pay credit event could be in the crosshairs for CDS protection buyers either in the month after 30 June or after 30 September. Moreover, Casino and its conciliators ‘share the objective of reaching an agreement in principle with the main creditors on the restructuring of the group’s financial debt by the end of July’”.

The negative newsurrounding SBB continues apace, with founder and former CEO Ilija Batljan selling his stake in Swedish property company Logistea for SEK 290m. He is reportedly facing a number of margin calls on loans backed by his SBB shareholding. SBB shares have tanked over 32% in the past week, not helped by news that the Swedish Financial Authority is investigating whether SBB broke real estate valuation accounting rules in its 2021 accounts. 

Kyma Capital and LMR Partners, part of The Support Club, a group of disgruntled Orpea unsecured bondholders, have persuaded the Delaware District Court to subpoena Anchorage (part of a steerco) and their advisors PJT Partners to provide documents related to the French Care Home group’s restructuring, now in Sauvegarde Acceleree. The two funds allege the SteerCo are being “arbitrarily enriched under the restructuring agreement, to the detriment of a huge proportion of the other unsecured creditors and other equity investors”.

While I was sunning myself in Sussex last Friday, Hilding Anders was in the English High Court launching its Scheme of Arrangement. The Swedish bed manufacturer failed to bounce back and is having to restructure its debt for the second summer in a row. As a result, sponsor KKR will hand over the keys to the lenders, who have had to stump up €20m of emergency financing to keep the company afloat after “unforeseen liquidity issues”.

And Robus Capital’s counter-motion for Metalcorp was favoured by bondholders. As David Graves outlined the motions put forward by Robus expanded on Metalcorp’s earlier management buyout (MBO) plan, under which the European side of the business is being acquired by Ferralum (owned by existing management) for zero cash. Ferralum will instead assume a portion of the bond debt. Under the counter-motions, Metalcorp’s two bonds — the €70m 8.5% 2023 SSNs and the €300m 8.5% 2026 SSNs — will be separated into three new debt instruments, each with varying degrees of seniority, split between the two post-buyout entities.

Earlier in my journalistic career, when learning about how leveraged loans worked, the concept was all about generating enough free cash flow to meet scheduled amortisation payments and deleveraging enough to refinance cheaper, three or four years down the line. How quaint. 

In recent years, your only hope of being refinanced is that rates would be lower, deal multiples higher, and that your debt isn’t portable to the next PE buyer playing pass the parcel. 

I was reminded by LinkedIn that it was 10 years ago that the Federal Reserve issued its LevLoan guidelines — hat tip Alastair Matchett from Financial Edge — who summarises them below

Time to run some screeners on 9fin, to see how many deals of today would comply?

As a child in the 1970s, I remember the phrase “the British Disease” and being called the “sick man of Europe” (historians will know that this phrase was first used to talk about the decline of the Ottoman Empire). 

So why is Britain facing higher inflation than other G7 members? Ed Conway from Sky has the answer, and it involves cucumbers and wholesalers selling fruit and veg below cost

Most are grown in greenhouses and pumped full of Co2 to boost growth, are very energy intensive and require significant amounts of fertiliser. You can work out the rest. 

Btw cucumber prices are up 50% in a year!

The latest rises in interest rates and scare stories about mortgage costs dominated the headlines this week. As a fresh home buyer in the late 80s who saw his mortgage double in six months (rates hit 14%) I can sympathise, but I disagree with Telegraph readers that mortgage holders’ pain was worse back then. Remember, it’s all proportionate. A fixed rate at 2% rolling off and being refinanced at 6% could be worse than going from 7% to 14%, especially given the higher LTVs and earnings multiples now on offer. 

Tim Harford’s More or Less on Radio 4 this week explains this much better than I have above. 

The key question here is how much this will affect the housing market. If Mortgage costs go up by X, house prices in theory should go down by Y to compensate for the reduced affordability. But there is the scarcity factor, amid hopes the Bank of England won’t want to crash the market. 

I am currently sweating on a house purchase (hope to exchange next month, my mortgage offer would be another 1.25% higher already), and increasingly worried I may have overpaid, so Bill Blain’s Morning Porridge last Thursday, wasn’t very digestible. 

The UK Housing Market is a metaphor for confidence in the UK economy – and it is looking wobbly

“The UK housing market is at its highest income multiple since the 1850s, at a time when real incomes have flatlined for two decades, and mortgage borrowers are levered higher than ever – it is set for a wobble, sustained only by supply shortages. If it crashes.. all bets on the UK will need to be re-examined.” 

Despite my imminent purchase, I do agree with Bill that the Housing Market is broken, there is real pain for a whole generation of people — who we should be investing in to revive the UK’s prospects — and could drive the political debate for next few years, and even stoke social unrest. 

“To avoid a fundamental collapse in UK housing based on the unaffordability of homes, falling real incomes, and leverage (high mortgage repayments) we need to engineer a soft landing. The obvious way would be to encourage more house building, raise real wages so they become affordable – but that would mean an element of inflation, which would actually smooth the process. The alternative is rising unaffordability, the perception only the rich can afford homes, angry renters and an element of political populism leading to chaotic polices like nationalisation of rental property, rent controls and such. That way lies madness.”

Perhaps its time to retire to the South Downs and keep bees. The beer is better looked after and cheaper! Time to hit publish and down a pint of Harvey’s Best.

Friday Workout — Market for Lemons; Past Imperfect, Future Perfect

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