A tale of two retail loan markets

COVID-19 split the retail financing market—players of scale with online capabilities thrived, while retailers reliant on brick-and-mortar stores for the bulk of their earnings came under increasing financial pressure

Retail leveraged finance activity in the United States and Western and Southern Europe was unpredictable and volatile in 2020, even before COVID-19 locked the doors of retailers around the world.

Despite continuing uncertainty, consumer retail high yield bond and leveraged loan issuance across the two regions for the first nine months of 2020 climbed 42% year-on-year, from US$37.2 billion in 2019 to US$52.9 billion.

Retail stocks are also up—the FTSE 350 General Retailers index is up by just under 10% for the year and the S&P Retail Select Industry Index climbed by almost a quarter in the past 12 months.

But even as leveraged finance issuance and equity values have climbed, so has the number of restructuring and bankruptcy cases in the sector. 

By mid-September 2020, 46 US retailers had filed for bankruptcy, more than the total number of filings for any year since 2010. In Europe, the German Retail Foundation forecasts that 50,000 retail locations generating €40 billion of revenue are at risk of closing. In the UK, more brick-and-mortar retailers had gone into administration by the end of June than in all of 2019, according to the Centre for Retail Research.

A bifurcating market

Lockdowns accelerated the decline of brick-and-mortar franchises and physical non-food retailers. Yet despite the distress in the sector, some retailers delivered strong growth through the pandemic period. 

For example, Walmart reported a 97% surge in online sales for H1 2020, Amazon posted record Q2 earnings just as others were struggling and digital disruptors like Instacart, which landed a US$17.7 billion valuation after a recent fundraising round, continued to flourish. 

Retailers with scale and online capability were able to access capital markets as required, despite the severe initial dislocation caused by COVID-19. Walgreens Boots Alliance, Costco, Target and Kroger all raised debt early in the pandemic period. Retailers like Costco and Kroger, which offer distinctive product mixes that include essential grocery items, have been well positioned to take advantage of resilient consumer spending in these areas. Retailers with sophisticated online platforms, like Amazon and Walmart, have also performed strongly.

For retailers outside this category, however, financing has been difficult to source and the priority has been survival rather than growth.

Navigating distress

While capital markets have been effectively closed for many retailers, for some they have been open but expensive. For example, retail chains Kohl’s and Nordstrom managed to raise bond financing in April, but at yields of 9.5% and 8.75%, respectively.

Under the circumstances, restructuring was inevitable in the sector.

Some retailers under financial pressure have restructured balance sheets by trading out unsecured bonds and loans for first lien secured debt. This doesn’t necessarily bring in new money, but reduces financing costs. Other retailers, looking to generate liquidity, shifted some assets into unrestricted subsidiaries, using those assets as collateral for new financings.

Unrestricted subsidiaries allow companies to take on additional debt against assets which are out of the reach of the covenants restricting debt incurrence.

Investors have sought to clamp down on the use of unrestricted subsidiaries following aggressive use of the structures by retailers like J. Crew, Revlon and Claire’s Stores in recent years, but those structures remain commonplace in many existing debt agreements. Since the onset of the pandemic, lenders and investors have, however, often insisted on blocker terms that identify particular crown jewel assets and intellectual property that cannot be dropped into unrestricted subsidiaries.

For struggling retailers with large real estate portfolios, sale-and-leaseback deals have provided another liquidity line. After filing for Chapter 11, for example, J.C. Penney outlined plans to separate its real estate business into a publicly-traded real estate investment trust to sell its distribution centers in a sale-and-leaseback deal to raise additional cash. Weak real estate markets have diluted the value that retailers have been able to extract from property portfolios, but sale-and-leasebacks have provided some liquidity.

Asset-based lending (ABL) facilities, which are typically secured against inventory and receivables, have been another important source of liquidity for retailers when other credit lines have been unavailable. ABL lenders have generally come out of retail bankruptcies intact and have been open to exiting their positions with replacement facilities on tighter terms.

Distressed investors circle

Restructurings have also been driven by distressed debt and turnaround investors who have bought up debt positions in the capital structures of retailers at deep discounts in anticipation of companies going into workout situations. 

Retail loans have traded at steeper discounts to the wider market, according to Debtwire Par, providing distressed investors with an opportunity to build up exposures to assets at reduced cost. Some of these investors buy into retail positions with a view to taking equity ownership in the event of bankruptcy after clearing liabilities and right-sizing balance sheets.

The debt holders of J.C. Penney, for example, which include H/2 Capital Partners, Silver Point Capital, Sculptor Capital Management, Brigade Capital Management and Sixth Street Partners, are considering plans to team up and bring in new third party investment to take ownership of the retail chain after it declared bankruptcy earlier this year.

But in a sector still vulnerable to another round of closures following a second wave of COVID-19, and reduced foot traffic in stores and malls, any investment strategy targeting retail is not for the faint of heart.

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