The Chewy IPO and its Implications for Unsecured Bondholders

In April 2019, PetSmart (the pet products retailer owned by private equity firm BC Partners) announced that it would IPO its online retail subsidiary Chewy Inc. On June 14, 2019, CHWY began trading on the NYSE. Priced at $22 per share upon IPO, its valuation increased by 59% at market close and it currently boasts a market capitalization of $13.3 billion.

While there is ongoing debate regarding whether Chewy, an unprofitable online retailer, should be worth this much or deserves to be labeled as a “tech unicorn”, this write-up will not be a discussion on Chewy’s valuation and stock performance. Instead, I want to bring your attention to the implications of this IPO for PetSmart and their debt that traded at distressed levels not long ago.

PetSmart, for most of its operating history, was not a debt-laden business. As the “retail apocalypse” commenced at the beginning of the 2000s, the brick-and-mortar retailer remained quite financially healthy. Perhaps this was why it became a LBO candidate for BC Partners in December 2014. Two years later, PetSmart acquired Chewy, an acquisition that was also largely funded with debt. At the time of the acquisition, Chewy was made a guarantor of PetSmart’s existing debt and Chewy’s assets were pledged to PetSmart’s term loan as collateral. As of 2019, the capital structure of PetSmart is as follows:

· $900 million asset-based revolver

· $4 billion first-lien term loan due 2022

· $1.3 billion 5.875% first-lien senior secured bonds due 2025

· $1.9 billion 7.125% senior unsecured bonds due 2023

· $650 million 8.875% senior unsecured bonds due 2025

With an estimated EV of $3.9 billion by S&P Global in November 2018, it was evident that the company was distressed. What truly shocked creditors was PetSmart’s subsequent behaviour in spite of this distress.

In June of 2018, PetSmart moved 20% of Chewy’s equity interest (valued at $908.5 million by PetSmart) into an entity held by an investor group led by BC Partners, and another 16.5% (valued at $749.5 million) into an unrestricted subsidiary. As a result, PetSmart’s creditors now only had access to 63.5% of Chewy’s value in the event of bankruptcy. This maneuver had exploited a loophole in the original credit agreement which enshrined Chewy’s guarantee of PetSmart’s debt. Since Chewy had to be a “wholly-owned” subsidiary of PetSmart for the guarantee and asset pledge to be effective, the equity transfer rendered the terms unenforceable in spirit. This meant that PetSmart creditors would only have access to 63.5% of the residual value of Chewy and would be structurally subordinated to any debt incurred at the Chewy level.

PetSmart’s creditors were predictably unhappy. Following the announcement of the equity transfer, unsecured bonds due 2023 traded as low as 48 cents on the dollar. When PetSmart filed a lawsuit against its term loan facility for failing to release the guarantee and liens, the term loan agent responded by contending that the Chewy equity interest transactions were unlawful. The term loan agent’s counterclaim was based on three assertions:

- In the transaction that saw 20% of Chewy’s equity being transferred to the investor’s group, it took place under the restricted payments basket. In order for the restricted payment to take place, PetSmart had to pass a leverage test. However, PetSmart only passed the test due to significant amounts of EBITDA add-backs that the term loan agent had ultimately refused to recognize.

- In the other transaction where 16.5% was transferred to an unrestricted subsidiary, PetSmart used an “investment in a similar business” basket. However, this unrestricted subsidiary currently does not operate any “similar businesses”, and its sole role is to hold the Chewy shares. This does not satisfy the requirements for this investment basket.

- PetSmart deliberately under-evaluated Chewy with its valuation at $4.45 billion, and for the 36.5% equity interest that was transferred, they should have been worth substantially more than the baskets would have allowed.

The counterclaim was ultimately settled out of court in April after the term loan holders agreed to an offer PetSmart made: PetSmart would IPO Chewy as soon as possible and use all proceeds to pay down the secured creditors. It would also pledge all future proceeds to prepayment of the term loan in the event of asset sales — essentially recreating the guarantee and collateralization, but only for the term loan. In return, the term loan creditors agreed to not pursue any further litigation regarding the equity interest transfer. This seemed fair and, if anything, the push for debt prepayment made the term loan holders even happier than they originally were — the term loan price immediately shot up to 96 cents on the dollar following the announcement of the Chewy IPO. Now that Chewy has IPOed and its market capitalization is over $13 billion, there is no clear reason for the secured bondholders to be upset.

But where does this leave the unsecured bondholders?

The unsecured bonds due 2023 have climbed to about 95 cents on the dollar last week. Along with the secured lenders, unsecured bondholders are ecstatic at Chewy’s successful IPO. At first glance, even with the 36.5% equity stake out of the question, it appears that they should be able to recover way more than what they had previously thought. After all, Chewy’s market capitalization is at $13.3 billion while the purchase price was originally $3 billion (the unsecured bonds were issued to fund the purchase).

I argue that this conclusion is drawn too hastily. There are major issues that still exist as result of PetSmart’s settlement with the term loan holders, and the IPO has not changed much of the risks that the unsecured bondholders face in their position.

The out-of-court settlement PetSmart had with the term loan has put the unsecured bonds in a significantly worse position. Prior to the settlement, because the unsecured bonds were pari passu with the term loans and secured bonds, the value they would have received in Chewy was proportionate. While it would still be the residual value out of the 63.5% equity interest, the unsecured bonds were no longer subordinated as the pledges of Chewy assets for the secured loans had been canceled by PetSmart’s maneuver. I want to highlight this fact as if anything, the 36.5% transfer of equity has put the unsecured noteholders in a better position because of this reason. Despite losing the ability to access 36.5% of Chewy in the event of default, being subordinated to over $5 billion of secured debt was far more hurtful to recovery.

All of this changed after the out-of-court settlement; the unsecured bondholders were once again relegated to their original position. Their recovery from Chewy is once again subordinated to the secured holders due to new asset pledges. In fact, their position has worsened as PetSmart will also attempt to accelerate the prepayment of the term loan. This will deteriorate the ability for the unsecured bondholders to claim repayment as it is an additional use of cash that PetSmart/Chewy was not responsible for previously. In sum, in addition to only having access to the 63.5% of the pie, the unsecured bondholders are once again subordinated to over $5 billion and see their credit support exacerbated by PetSmart’s prepayment of the secured debt.

Regarding the highly successful IPO itself, as much as the “pie” in question has significantly enlarged in size (from $3 billion to $4 billion to $13 billion), it is unclear as to whether this benefit reaches the unsecured bondholders. After all, they had initially provided capital to a brick-and-mortar pet products retailer whose bond value now relies on its eCommerce subsidiary. Labelled as a “tech unicorn” despite not being “tech” related or a “unicorn,” Chewy’s valuation could fluctuate significantly due to tech stocks’ general volatility. If a distressed sale becomes inevitable, Chewy’s price will also become significantly compressed as well due to the nature of distressed M&As. Furthermore, its credit support and payment capacity are not going to improve just because its public markets valuation is tremendous. As such, I do not believe this valuation on the public markets is necessarily indicative of Chewy’s unsecured bondholders being in a better position.

Investor alignment should be considered as well. Prior to this IPO, BC Partners and its investor group were aligned with the creditors in their objective of expanding the value of PetSmart and its subsidiaries. If the creditors were unable to have a full recovery, it is unlikely that the equity investors could obtain anything aside from the 36.5% of Chewy that they had sequestered. Now that Chewy has IPOed, the 36.5% stake is worth approximately $5 billion, a significantly larger sum compared to the investor group’s original $2 billion equity investment. Their motivation to continue to create long-term value and turn around the PetSmart business would have certainly diminished since they can cash out any second. The resultant principal-agent problem is much more impactful to the unsecured lenders than the secured ones since, in the event of a restructuring, the unsecured lenders will need the business to be at a higher value to be able to make any recoveries.

With these potential risks in the backdrop, the unsecured bondholders should use the opportunity of the IPO to, like their term loan peers, lobby for better amendments. All of the arguments made by the term loan agent in its counterclaim are still relevant for the unsecured class and are possibly even stronger due to the IPO.

One of the key issues raised by the counterclaim was Chewy’s valuation. The term loan agent originally pointed out that this violated the affiliated transactions covenant; as Chewy’s equity interests should have been worth more, a 36.5% equity interest transfer violated the baskets’ size restraints. This was, however, difficult to prove in court given the ambiguous nature of private company valuations, and the fact that the valuation was done by a third-party. Now that the IPO has occurred and the market capitalization is at $13.3 billion (nearly 3 times that of PetSmart’s valuation prior to the transfers), the valuation challenge becomes much more compelling. If the unsecured lenders could either be guaranteed by Chewy once more or receive a second-lien pledge on Chewy’s assets, the risks mentioned above would be greatly mitigated.

In a modern credit environment where covenants are becoming increasingly violable, lenders must proactively fight for their rights and address problematic happenings before they become bad precedents. With PetSmart becoming a prime “J. Crew backdoor” example in 2018, its unsecured lenders should use this IPO as an opportunity to pursue increased covenant protection on their bonds. They must remember that anything can happen between now and maturity.

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