Market Wrap

Friday Workout — Solvency Too; Remedy, Organise, Rally

Chris Haffenden's avatar
  1. Chris Haffenden
17 min read

Well, that escalated quickly. Hours after the ink dried on last week’s Friday Workout, FTX Group — and 130 of its companies including Alameda Research — filed for Chapter 11 protection.

In their initial filing FTX lawyers said:

The events that have befallen FTX over the past week are unprecedented. Barely more than a week ago, FTX, led by its co-founder Sam Bankman-Fried, was regarded as one of the most respected and innovative companies in the crypto industry. The Debtors operated the world's second largest cryptocurrency exchange (through its and platforms), operated one of the largest market-makers in digital assets (through Alameda Research LLC and its affiliates), and conducted diverse private investment and other businesses.”

They added:

FTX faced a severe liquidity crisis that necessitated the filing of these cases on an emergency basis last Friday. Questions arose about Mr. Bankman-Fried's leadership and the handling of FTX's complex array of assets and businesses under his direction.”

Worryingly, on the same day of the filing $103m disappeared from FTX accounts via a supposed hack from a FTX employee using the Kraken exchange. In a Twitter post on 13 November, Kraken said it had frozen the accounts associated with “FTX Group, Alameda Research, and their executives.”

This was “to protect their creditors,” with the exchange telling Cointelegraph it had “actively monitored recent developments with the FTX estate” and “are in contact with law enforcement,” saying it froze account access to certain funds “we suspect to be associated with ‘fraud, negligence or misconduct’ related to FTX.”

FTX sources then told Reuters that $1bn-$2bn of client money was unaccounted for in the company’s spreadsheet. The narrative of a run on the crypto exchange which couldn’t satisfy an abnormally large amount of customer withdrawals, but was a fundamentally sound business nonetheless, had unravelled at breakneck speed.

Cue a plethora of articles from mainstream financial media seeking to explain what might have gone wrong, as the Effective Altruist gave it all away (and some more).

Attributed to unnamed sources within FTX it was suggested that Alameda (the internal hedge fund) which was by far the exchanges’ biggest customer had borrowed billions in FTX customer funds to make bets on Crypto (and invest in venture capital). If true, this would be in violation of US Securities law on the co-mingling of funds and their use without explicit customer consent.

Meanwhile, the industry (and Sam Bankman-Fried (SBF) in several of his communications) are trying to pass this off as a liquidity issue. Without any hint of irony, Changpeng Zhao (CZ) the CEO of Binance tweeted this week about setting up a recovery fund “to help projects who are otherwise strong, but in a liquidity crisis.” The crypto buyer of last resort? A crypto Central Bank?

Wasn’t that what SBF had done earlier in the year? I wonder what sources of liquidity CZ is drinking?

Solvency Too?

I totally agree with Matt Levine in his excellent piece from earlier this week:

“…every crypto liquidity crisis story that I have heard is obviously a solvency crisis. The problem is not that the firm has good assets but cannot, for some reason, convert them quickly into ready money. The problem is that the firm has bad assets and people notice and demand their money back and the money isn’t there. The reasons the money isn’t there will vary. Sometimes the firm just lost money on risky trades. Sometimes the money all went into magic beans and the magic bean market collapsed. (This is the story of TerraUSD and Luna.) Sometimes the money was stolen by hackers, or by the firm’s executives, or both.”

Matt Levine goes on to say:

But the story is never “this crypto firm took demand deposits and used them to fund 30-year mortgages, and while those mortgages are still paying and are likely to be money-good, the firm doesn’t have the cash right now.” Because that is, uh, not really how crypto works? Compared to banks, crypto firms probably have a bit more carelessness and fraud, but they definitely have a lot more magic beans. Crypto firms tend to have assets that do not have cash flows, and that are highly correlated to confidence in crypto — often highly correlated to confidence in that firm itself — and so when they lose confidence they also tend to lose their assets.”

And yesterday, boom.

In their 30-page filing yesterday with the bankruptcy court what do we find?

Huge related party loans from Alameda Research (FTX’s hedge fund) including a $1bn personal loan to SBF and $542m to the director of engineering

They also disclosed that FTX never hosted board meetings, there was no centralised cash management system and no record of who they employed adding that “certain employees can’t be located.” Corporate funds were frequently used to purchase real estate for employees.

And get this. Customer Crypto deposits were not even recorded on their balance sheet! I assume everything was just co-mingled and available for use as FTX/Alameda/SBF saw fit.

In the end, as Stephen Diehl says in an entertaining and hyperbolic Substack post:

The entire FTX operation screamed scam to anyone who could do even the most basic due diligence on the operation. Did anyone ever ask why hordes of mum-and-pop retail investors were wiring money to a shady entity called ‘West Realm Shires Services Ltd’ just so that they could become an unsecured creditor to a Bahamanian shell company to purchase derivatives of completely abstract financial assets whose only demand is driven by popular sentiment about a meme of a talking dog?”

Remedy, Organise, Rally

Once confidence is lost, it can be hard to regain. This is the challenge facing the new management team at Orpea, the troubled French Care Home operator, who have been in situ since July 2022. This Tuesday (15 November 2022) was their big reveal, a transformation plan to form the basis for their upcoming debt restructuring, the largest in Europe this year.

Rocked by allegations of mistreatment of patients, staff shortages and improper use of French Government subsidies, the group had struggled to regain full occupancy at its homes. Over the past few years, it had grown fast by building and acquiring new care homes, whose values had been marked ever higher, but rising interest rates had hit values and transactions ground to a halt. An ambitious plan to sell over €2bn of properties to meet upcoming maturities has since floundered, which won’t be a big surprise to 9fin subscribers.

This led to a second conciliation process with creditors in less than five months with Orpea indicating that unsecured creditors could be fully equitised, with a substantial new money need to boot. Last weekend the French press had leaked that CDC and AG2R would answer a call for French long-term institutional investors with up to 29.9% of the equity to be made available.

But speaking to 9fin on Monday, CDC said there are conditions attached. As 9fin’s Lara Gibson writes:

To get comfortable with their proposed investment, CDC would need Orpea to overhaul its operating practices and “sanitise” its balance sheets, the spokesperson added. CDC would like Orpea to have a fair chance at recovering its financial performance without needing to target “excessive margins.”

She adds:

It’s worth noting that Orpea’s widely documented allegations of malpractice largely stemmed from its care home managers attempting to cut costs. The state-backed investor has an obligation to act in the best interest of the French people as well as in its own financial interests.

With the above in mind it was no surprise that management spent a significant amount of time in their gargantuan 86 slide presentation and an hour-and-a half of their three hour plus conference call talking about how they were going to transform the business by improving their practices, changing the culture, with greater transparency. They would:

The management team said they had three goals: to Remedy, Organise and Rally. On arrival they had found dysfunctional management practices, a lack of attention given to employees, opaque financial reporting, embryonic financial controlling and a lack of a real estate database.

It isn’t until slide 51 out of 86 (at 10.50am, the call started at 9.30am!) that we get to the real estate section and find some numbers to assess. (Big thanks to 9fin’s distressed credit analyst Denitsa Stoyanova for her stoicism here). For other stoics, the full replay of the marathon broadcast is here

Orpea previously outlined that it was seeking to dispose of around €2bn of its real estate between 2022 and 2025. But it has only been able to offload €125m of Netherlands assets. Negotiations over the sales have become tougher since October, according to management, which signalled that a few medium size deals might be completed, but there is no certainty, and no solid prospects for significant deals to be completed within a reasonable timeframe.

The new management said they thought they had €1.2bn of real estate development assets, but cautioned that there is no real inventory and some do not have documents to confirm ownership. They revealed they had carried out an asset-by-asset audit of the real estate portfolio for the first time, which led to the large asset impairment in October 2022.

But rather than learning from past mistakes and hitting the pause button to preserve liquidity and get to grips with their estate, they are ploughing ahead and spending €1.575bn (63% of their €2.5bn investment plan) on renovation and construction, or put another way, the bulk of their proposed new money need.

Over the long term, they want to own 20-25% of its real estate portfolio (vs 47% at end-FY 21) and establish a new real estate investment vehicle in the medium term “to increase monetisation alternatives at that entity level.” We assume this is some form of REIT structure.

In countries in which it doesn’t have a “sufficiently attractive position” the group said it will consider restructuring or exiting operations, with many international markets loss-making.

Luckily, ‘several billions’ of real estate assets are unencumbered which should fix their short term liquidity needs, via €600m of new senior secured debt (hopefully backed with conservatively revalued property).

It is also worth noting the presence of very large operating lease rental expense (per management the rentals will be €440m in FY 23 rising to €500m in FY 25), notes Denitsa. This is a massive cash drain – why hasn’t the leases been included in the restructuring? Surely they can re-negotiate the terms for a few years until they get back on their feet?

So, what else is in the plan?

Up to €3.8bn of subordinated debt will be equitised, with up to 20% of the shares to be made available for French long-term institutional investors (we assume for political and governance reasons).

The debt-for-equity swap will be implemented via a rights issue to existing shareholders and backstopped by unsecured lenders. In addition there is €1.9bn-€2.1bn of new money (€600m of this is the new secured debt) and the remainder coming via a second share capital increase.

Existing senior secured debt at the Orpea SA HoldCo (put in place during the first conciliation in June 2022) will be extended to June 2028, with margins reduced to 175 bps (some NPV haircut here) and early repayment clauses linked to asset disposals removed.

But securing agreement from creditors might be problematic as the group’s debt structure is highly complex, with €7.9bn of debt sitting across 738 different credit lines. Hundreds of lawyers have been employed to figure out which debt sits with whom and to track down documentation on asset ownership, management said.

Clueless on Valuation

Management admitted on the call that they have no idea on valuation of the company, and they have not yet thought about it. They added they have not decided if the Debt-for-Equity swap and the share capital raise will be done at the same share price.

Not a great start for those looking to provide up to €1.5bn of equity, which the company wants as binding commitments by mid-January 2023. We assume that new money providers would want to be incentivised by more preferential equity terms.

Asset backing is another key consideration for equity providers. What is the revised real estate value? The property portfolio was valued at €8.4bn in H1 22 (41-43% of total assets). But Orpea has said that a 0.25% increase in cap rates results in a €240m hit to asset value.

With such sensitivity, a €1bn plus hit is not out of the question, given recent rate moves. With over €5bn of secured debt (down from €9.5bn) left in the structure, this leaves the LTV dangerously high, potentially in the 70s.

What do we know about the current financial position and the business plan?

The starting point isn’t great. Orpea will be 25x levered by end-FY 22. But this is expected to drop to 6.5x by FY 25 if the business plan and restructuring plan are implemented. That’s hopeful, as there could be some equity value say, if we assume 8-9x valuation.

But the new business plan expects revenues to grow at a CAGR of 9%, which at face value looks optimistic. This is driven by 1) price rises in line with inflation, 2) larger footprint (facilities to grow by 4% per year and beds by 3.3%), and 3) return to pre-Covid occupancy rates, particularly in France, where occupancy is expected to rise from 85% currently to 95% by 2025.

But reopening beds will depend on improving staffing levels. The group is hiring at least 500 employees per month, with 5,000 positions needing to be filled in France alone. But conversely, Orpea is aiming to lower staff costs from 58.6% of revenues in 2022 to 56.4% of revenues in 2025. This it says will be achieved by reducing the number of agency contracts, lowering the number of accidents and improving the level of absenteeism.

In France it estimates they pay care workers on average 10% below what public and private hospitals pay, which explains their historical staffing issues. To make matters worse, the group had operated without collective bargaining agreements for the last 15 years, and it was only last week that it had finally reached agreement with employee representatives. Frustratingly, details of the wage settlement were not disclosed.

All in all, a lot of execution risk and not as much transparency (so far) as we had hoped.

In total, the Orpea initiatives make up €250-280m of the €449m of EBITDAR growth from 2022 to 2025 (from €797m in FY 22 to €1.246bn in FY 25). Another €170-180m of EBITDAR comes from ‘development impact’.

Is the timeframe realistic?

The next meeting of unsecured creditors under the conciliation procedure is coming up fast on 1 December 2022.

Orpea says it expects binding offers for its new €600m secured debt by mid-January and to be able to fund during February 2023. This is tight, but should be achievable.

Binding offers for the equity raise will be sought for the middle of January 2023. This is tight, unless, distressed funds have provided firm commitments for €1.5bn. But as outlined above, I would have thought a lot more detail is needed on the business plan, and a lot of due diligence before these indicative offers become binding.

Implementation is likely via Sauvegarde Accleree, which is relatively quick and requires just 2/3 acceptance from creditor classes. But with numerous unsecured lines and individual creditors, Orpea may need 2/3 of senior creditors to cram down the juniors. For more details on the process, see our French Insolvency Primer on our website here.

Completion of the debt-for-equity swap is expected in June 2023, which coincides with when the restructuring process is due to conclude.

And while the call was going on — a number of Orpea care homes were being raided!

“Dozens of facilities of French nursing home operator Orpea have been raided simultaneously on Tuesday as part of a judicial investigation into suspected “institutional mistreatment”, the Nanterre prosecutor told Reuters, confirming a report in French investigative website Mediapart.”

Surely, the timing of the raids cannot have been such a coincidence. We did post a question into the Q&A queue, but it went unanswered, and Orpea has yet to publicly respond to the move.

Upfield bonds on an Up Tear

On Thursday, I was moderating a creditor-on-creditor violence breakfast panel for Simpson Thacher. I will leave most of the details and takeaways at the event for a detailed piece I’m working on, but the main points were going through US up-tiering and drop-down deal structures, latest litigation moves and discussed whether these deals could become prevalent over here.

To whet your appetite and as a refresher our legal team produced a 9fin Educational called Priority of Debt — Getting Primed, earlier this week and is available on our public website here.

One European candidate often talked about by investors and lawyers alike is KKR’s Upfield Flora. As we previously reported, with leverage sitting with an 8-handle, the sponsor’s investment is close being underwater. With loose docs, some Envision that advisors would be pushing aggressive solutions to the Dutch margarine and plant-based food group, with almost €2bn of sponsor equity to protect.

As 9fin’s Caitlin Carey and Christine Tognoli outline in a report KKR “is no stranger to creative structuring techniques to manage its portfolio companies’ capital structures.” They said there are a number of possible structures KKR could use to incur priming debt and undertake below-par buybacks/exchanges of its existing debt.

The transfer of assets to an Unrestricted Subsidiary and raising of structurally senior debt outside the Restricted Group – could be permitted under Upfield’s bond covenants. However, there are also some aspects where this would be more complicated in European debt structures.

But could all this be academic?

As 9fin’s Emmet McNally reports, after the release of a Q3 trading update late on Wednesday night, for the second quarter running its bonds have rallied sharply after earnings surprised to the upside. Its SUNs rose by around 6-8 points on Thursday.

Could it have been any butter? Maintaining the spread between surging butter prices and cheaper Flora margarine, meant that prices of its products rose by 37% YoY, outstripping input cost inflation for the first time this year, leading to a 31% increase in normalised EBITDA despite a 12.6% drop in volumes.

As Emmet notes:

“Crucially, the considerably stronger nominal EBITDA in Q3 22 combined with moderate growth in balance sheet cash drove notable de-leveraging with Upfield already reaching the year-end 8x net leverage target. We noted in our review of Q2 22 earnings that the FY 22 outlook outlined at the time looked achievable.

Now, the company is guiding for year-end leverage to come in below their prior 8x target. Q4 22 looks set to be another decent quarter for earnings, judging from slightly altered guidance and typical seasonality in the business.”

Emmet thinks it could get down to 7.5x by year end. Performance for 2023 is less certain, given under-hedging of vegetable oil and natural gas. Interest rate hedging on its debt has also expired (80% is floating) meaning higher interest charges ahead.

In brief

With under two weeks to its convertible bond maturity, Corestate has yet to reach agreement with its creditors on a restructuring plan. As 9fin’s Bianca Boorer reports, the German real estate operator is asking its creditors to vote on two opposing restructuring concepts on 28 November, which coincides with the maturity date of its €188m (outstanding amount) convertible bonds.

In addition to the two proposals, it submitted a fall-back solution to extend its convertibles to 30 April, the maturity date of its €300m SUNs, for creditor approval. Even if bondholders vote in favour of this fall back solution, to allow more time for negotiations, the group still faces the risk of being declared insolvent if it is unable to resolve a negative equity position.

Codere gambles on a €45m liquidity programmeDespite impressive top line growth, liquidity remains hard to come by for Spanish gambling and betting operator as margins are squeezed, notes 9fin’s Nathan Mitchell. This is affecting liquidity, with its 2023 base case budget including a €45m liquidity programme.

At the time of its debt restructuring late last year, the company had projected FY 22 net leverage on €277.8m Adjusted EBITDA. Just three months shy of this date and Codere’s LTM Adjusted EBITDA is €198.9m, 5.1x net debt. To avoid falling short on its estimates, a monstrous €123.9m of EBITDA is required in Q4.

Another blow for Adler from the regulator this week. BaFin has concluded that the German Real Estate group by €3.9bn and its earnings by €543m in 2019. The regulator said on Thursday that it incorrectly consolidated ADO Properties, despite only controlling just a third of its voting rights. This led to an underreporting of its LTV which would have been over 70%, and above the debt incurrence covenant on its bonds. But there was finally some good news this morning, with Adler disclosing that it is in advanced negotiations with bondholders to amend terms and conditions “as well as the provision of secured debt financing” — which we assume would provide financing to keep the business afloat while a restructuring is concluded.

What we are reading this week

Most of my reading was related to my Breakfast Panel, and is probably too dry for Friday consumption, a series of court rulings and lawyer briefings on UpTiering transactions and drop downs. So apologies for a skinnier list than usual

FTX dominated our newsfeeds all week. Vox has a fascinating piece based on a Twitter DM exchange between their reporter Kelsey Piper and SBF, the fallen crypto angel.

SBF isn’t the next Warren Buffet as previously dubbed by Fortune Magazine or the second coming of George Soros, he is now being compared to Elizabeth Holmes and Bernie Madoff.

Is it also unravelling at Twitter? Elon Musk gave the 50% of remaining staff a 5pm deadline yesterday to commit to working “long hours at high intensity” and be “extremely hardcore” or they could leave with three-months pay. They had to click a link to commit to Twitter 2.0. Their offices today are locked (for reasons unknown) after hundreds reportedly decided not to become hardcore. I wouldn’t rule out another bizarre twist from the Big Twit in the coming days, who said he is not super worried. I wonder if his bankers brows are more furrowed.

In hindsight, the lack of due diligence is a common theme in the latest blow-ups. Thanks to 9fin’s WIll Caiger-Smith for sharing this thread from a former lawyer and a LP and GP who is disgusted with the lack of basic knowledge of investors when concluding due dil.

While FTX continues to implode, Bitcoin seems stuck in a tight range of between 15k and 17k. This means that MicroStrategy which has spend billions on Bitcoin from bond proceeds is sitting uncomfortably close to a big margin call at around 13.5k according to this thread from Element.

As the World Cup begins in Qatar at the weekend, expect plenty of distractions in the coming weeks. I will be supporting Ecuador — they have four Brighton players, including Moises Caicedo “He came from Ecuador to win the Balon d’Or” — and the coolest (away) shirt in the tournament

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