Structuring the Deal: Hudson’s Bay - Saks Acquisition

Canadian based Hudson’s Bay (HBC) agreed to acquire the New York luxury retailer Saks (SKS) for $2.9B ($2.4B equity plus $500MM assumed debt) Deal. The 9X EBITDA ($16 p/s) purchase price multiple represents a 20% premium to pre bid prices, and is consistent with recent transactions. HBC is controlled by NRDC LLC, a U.S. based real estate investment firm which owns Lord & Taylor (LT) department stores. The deal is funded with $1B of new equity supplied by the Ontario Teachers Pension Plan ($500MM), Canadian private equity firm West Face Capital ($250MM) and another $250MM from the public. Also, $1.9B in senior secured loans and $400MM in unsecured notes will be raised. The combined debt will initially exceed 5.7X EBITDA before reducing to a more manageable 4X after synergies. Management will remain in NY and $100MM in synergies are expected. The transaction was positively received with HBC’s shares jumping 6% on the announcement despite the potential dilutive stock placement. This is significant as HBC had a disappointing 2012 IPO. Investors were concerned over the entry of American competitors into HBC’s Canadian market.

Leveraged retailers are always problematic  -especially for those like SKS whose turnarounds are still in progress. Some commentators have rightly questioned the wisdom of the acquisition. They view it similar to the still troubled Eddie Lampert 2004 Sears/Kmart combination Sears.  SKS is a muddled brand lagging behind luxury retailers Nordstrom, which is planning to enter Canada, and private equity owned Neiman Marcus.

Ignored, however, is that the transaction is as much a real estate play as it is retail. SKS’ real estate value is estimated at $1.8B before debt with their signature Fifth Avenue location alone worth over $800MM.  The after debt p/s value of the real estate is $6.  Combined with LT’s real estate NRBC-HBC can monetize and unlock the real estate value thru techniques like a Real Estate Investment Trust (REIT) to create substantial tax benefits. A  Sale Leaseback (SLB) could then be used to raise proceeds to quickly deleverage the transaction from its high initial 5.7X leverage level. The combined LT and SKS real estate assets could support a $3.5B+ REIT, which could then be used to reduce debt. Rents would be stepped-up, and potential conflicts between retail and REIT units will need to be sorted out.

Undoubtedly, this is a high risk transaction given its relative size to HBC. They wisely sought joint venture type equity from sophisticated deep pocket investors to offset the risk. Also, the deal is structured more like an asset based real estate transaction than a traditional strategic retail acquisition. NRDC’s experience adds a degree of comfort in this area. Of course, they still have to complete the turnaround of SKS, achieve the promised synergies and adjust to higher rents. The expected use of clever financial engineering techniques like SLB and REIT appear to have enough value potential that the market awarded HBC a significant price increase. Hopefully, they can successful execute the deal and not disappoint investors. Bottom line-this is deal worth watching.

J

Back in Fashion Again: Financial Engineering to Enhance Debt Capacity

Private equity adds value in the following ways:

1) Buying right: reflected in low(er) purchase price multiples due to, for example, proprietary deal sourcing and market timing

2) Improving operating income: based on the sponsor's industry experience and management quality

3) Financial engineering: emphasis on taxes, leveraging and restructuring skills

4) Sell right: achieving multiple expansion based on improved operations and market timing

The focus of this post is on financial engineering to enhance debt capacity. An earlier post discussed internal debt capacity based on a firm's operating cash flow-EBITDA.  We will now examine how to supplement internal debt capacity using alternative financial instruments. These instruments were developed during the 2004/2007 leveraged transaction bull market to support rising purchase price multiples with increased leverage to maintain sponsor IRRs.  These instruments went dormant during the crisis, but have staged a remarkable return this year. Increased investor risk appetite in search for yield in a low rate environment underlies their return.

These instruments bear a strong resemblance to those used in the sub prime mortgage market. This is because they were developed by the same investment banks to solve the same problem; namely how to fund the fully priced deal. Note the comparison:

Private Equity and Subprime Affordability Products
	Subprime	Private Equity
Structured Products Used	Yes – Collateralized Mortgage obligations	Yes- Collateralized Loan Obligation
Interest Only	Yes- adjustable rate Mortgages	Tranche B Loans
Negative Amortization	Option Adjustable Rate Mortgages	Payment-In-Kind
Second Mortgage	Piggyback/Home Equity Loans	Second Lien
Liberal Documentation	Alt A	Covenant Lite

These instruments, along with high yield debt (HYD) and asset based lending (ABL), were directed at identified investor bases, primarily non bank institutional investors, to expand internal debt capacity. Now for a discussion of some of their features:

             Tranche B term loans: They have a higher spread than revolvers and term loan A tranches held by banks. They amortize 1% p.a. with a balloon maturity after the A's are repaid. Spreads vary by debt rating and are currently in the LIBOR plus 350-400bp range.

             Second Lien Loans are designed to utilize any excess collateral value remaining after the first lien loans are fully covered. They are directed at investors requiring secured debt. They are priced at significant premiums to the first lien debt, and present serious inter creditor problems in a workout.

             Alt A is short for Alternative A-paper-alternatives to conforming GSE backed mortgages due lack of traditional financial information.  Cov lite loans have limited financial covenants like fixed charge coverage minimums and maximum debt levels. Debtors dislike the limits on their flexibility. When breached they must amended or waived.

Institutional investors, unlike banks, prefer to sell their loan exposure in the secondary market if the credit worsens rather than dealing with an amendment. Hence they are primary holders of Cov lite. The usage of Cov lite has returned to pre crisis level albeit at lower volumes.

One of the first mega transactions to use an array of these products was the $33B HCA transaction in 2006.This allowed a private equity group to bid an aggressive 7.7X EBITDA purchase price by incurring a high leverage level of funded debt to EBITDA of 6.5X. Using this template, deal structures became progressively more complex and aggressive as sponsors searched for ways to expand debt capacity to support rising purchase price multiples.

Debt instruments (like my ties) go in and out of fashion depending on market conditions. The key is to check their market availability and pricing. Their utilization can provide an inexpensive and flexible means of supplementing debt capacity. They are and will remain essential tools in your financial engineering toolbox.

joe

p.s.my prior Best Buy post was validated by the much weaker financial results released on November 20th.Especially concerning is the over $500MM drop in projected EBITDA. Even though the stock price drop makes the deal "cheaper" the ability to finance a highly leveraged capital structure becomes even more remote.