Capital talk: Timing the market

This story about Victory Park Capital begins downstairs and around the corner from the firm’s Chicago office, where the smell of baked pizza wafts through a pair of revolving doors out to the sidewalk on West Jackson Boulevard.

It’s a rainy Tuesday afternoon and customers are crowding into the red and green booths in the dining room of Giordano’s Pizza. Servers hurry from the kitchen to deliver the restaurant’s daily lunch special, a six-inch Chicago style pie; thick crust shaped into a small bowl, filled with a hearty layer of mozzarella cheese and a tomato sauce, a cup of minestrone soup and a soda, all for $10. It’s clear, however, that the side and drink are secondary to the main course. “Pizza isn’t a matter of life and death,” says one placard above the bar. “It is much more important than that.”

Important enough to justify a $52 million investment, even. That was the price Victory Park (VPC) paid for Giordano’s assets in 2011, delivering the regional pizza chain from bankruptcy and reviving its prospects as an iconic Chicago eatery.

It also explains why Victory Park keeps a ceramic model of a Giordano’s deep-dish pizza in its conference room. It sits alongside dozens of other plaques and trophies commemorating the firm’s transactions, perched in a corner windowsill, with a view that overlooks downtown Chicago.

“We’ve done 46 deals,” says Brendan Carroll, who launched Victory Park alongside chief executive officer Richard Levy and fellow partner Matthew Ray in 2007. “It’s a lot different from what it was when we started. Private debt, even though it’s been around for a while, at least initially for the lower mid-market, wasn’t really a sector that a lot of the bigger institutions actively looked at.

“The current interest rate environment, and the desire for yield in any place you can find it, has helped us,” he adds, as he sips cherry cola from a Giordano’s mug. “We’ve been around now for seven years and our AUM has grown to a point where we do have institutionalisation, and we do have what we need to get those looks from larger investors.”

Providing debt and equity financing to recognisable brand names – even those with regional footprints, such as Giordano’s – is one way to get those looks. And as Victory Park plots its ascent (the firm is said to be fundraising, though its partners would not comment on the subject), the relatively young firm’s ability to maintain that support while delivering steady returns with downside protection will be key to its future success.

It’s a tough time for distressed firms, but the team at Victory Park believes it has found the right recipe.

FINDING DISTRESS

Identifying investors who are willing to commit capital to a distressed fund is no easy task, especially if you are marketing a distressed vehicle in a near-fully recovered North American economy.

Victory Park specialises in providing debt and equity capital to mid-market companies that are either distressed or “improving”, according to the firm’s website. That definition, though broad, can include everything from growth financing to bankruptcy acquisitions (as was the case with Giordano’s). No matter the situation, Carroll says all of Victory Park’s investments lead with credit first.

One of the firm’s earliest deals, an investment in nationwide smoothie chain Jamba Juice, saw it provide financing through the acquisition of a $25 million two-year senior secured note designed to improve the company’s financial flexibility through the economic downturn. For its recent investment in Surefire Industries, “credit first” meant acquiring virtually all of the assets of a distressed oilfield services business and replacing it with a stronger, more stable entity led by the same company president, Jamie Stewart. Whereas one deal provided transitional financing to a publicly traded company – at significant cost, LIBOR plus 8 to 12.5 percent, according to one report – the other represented a complete overhaul of a company’s balance sheet.

If fund performance provides any indication, Victory Park is equally capable of both. One of its clients is Sampo Group in Finland, whose investment in the firm’s $480 million VPC Fund II vehicle had appreciated from €9 million in late 2010 to €15 million as of 31 December, according to Sampo’s annual report.

Strong performance aside, it is still a difficult time to be raising capital.

Although distressed funds tracked by Bain & Company generated one-year returns of 18 percent in 2013 – the highest of any private equity-related asset class – commitments to new distressed funds fell by 16 percent, according to the consulting firm’s 2014 global private equity report. The decline in commitments was attributed to the steadily improving economy, which should, in theory, limit the number of potential companies to invest in.

“New capital flowing to funds that focus on distressed companies, which do well when the economy is struggling, was down in 2013, following several years of growth,” according to Bain. Bloomberg reported in June that distressed debt heavyweight Oaktree Capital Management had cut the $3 billion target on its latest distressed-for-control fund by 40 percent, citing a diminishing number of investment opportunities.

‘DISTRESSED ISN’T CYCLICAL’

While Carroll concedes that raising capital is never easy, Victory Park chief executive Richard Levy posits that distressed opportunities abound even in improved economic climates.

“What some people do not appreciate is that distressed is not a cycle,” he tells Private Debt Investor. “There are distressed opportunities in any environment, as can be seen by the fact that we’ve done two deals in the last six weeks, between Mi Pueblo and Surefire.”

The circumstances that brought the former to a distressed state speak to Levy’s point. Though troubled, Mi Pueblo Foods’ problems were hardly the result of poor financial performance alone.

The Northern California-based chain of 21 grocery stores caters to the region’s large Hispanic population, and although it remained stable through the financial crisis, it also drew the attention of US Immigration and Customs Enforcement (ICE). ICE launched an audit of the company’s hiring practices in 2012, citing concerns that Mi Pueblo employed illegal immigrants.
The audit prompted the company to join E-Verify, a highly controversial US Department of Homeland Security programme that allows business to confirm their employees’ immigration status.

The decision to implement E-Verify created tension within Mi Pueblo’s customer base, which includes many recent and first generation immigrants from Latin America. The criticism was particularly sharp given the background of Mi Pueblo founder Juvenal Chavez, who has described entering the US illegally from Mexico in media profiles. Perhaps more significantly, the audit and implementation of E-Verify depleted the company’s labour force.

“Though Mi Pueblo sought to ensure that its entire workforce was fully and accurately documented, ICE’s demands caused Mi Pueblo to terminate roughly 80 percent of its workforce since the first audit. Mi Pueblo was forced to replace terminated employees with less experienced personnel who, until they have had [three to four] months of experience, are less efficient and less able to meet the needs of Mi Pueblo’s customers,” according to an April filing.

The rapid contraction of its labour pool and backlash to the implementation of E-Verify coincided with a substantial decline in the grocery industry’s market share of food purchases, with comparable sales over the previous year dropping to as low as 15 percent in 2013, according to one Mi Pueblo filing.

The circumstances strained the grocery chain’s relationship with its lender, Wells Fargo, and although Mi Pueblo claims it never missed a payment, technical defaults under loan covenants in early 2013 resulted in a work-out plan that raised interest rates “and imposed additional performance and other covenants that were simply unachievable”, according to a filing. Mi Pueblo eventually declared bankruptcy in July 2013.

“When Mi Pueblo came along, we felt [it was] perfectly consistent with what our investment theme is, which is defensive investing, where we think there’s upside opportunity with the commensurate risk,” says Levy. “By that I mean, here’s an opportunity where there’s a lot of real estate value underlying the store, it’s not just a grocery store, which I think a lot of people think is a tough, lower margin business.

“The reason the company was in distress was driven by the huge labour issue they had. They had lost a lot of their skilled labor force overnight, which really hit revenue and margin. We felt that was something that could be solved over time.”
In January, Victory Park agreed to provide Mi Pueblo with $32.8 million in debtor-in-possession (DIP) financing to cash out Wells Fargo, as well as an additional $6 million that would fund the business through its exit from bankruptcy. The firm also agreed to provide an additional $56 million to pay out the DIP financing, as well as other claims Mi Pueblo needed to meet in order to emerge from bankruptcy.

“We replaced Wells Fargo not knowing whether we would end up being the partner or owner of this business,” says Levy. “We just stepped into the loan and provided incremental debtor- in-possession financing with the idea that we could partner with management to fix this, but not knowing whether or not the court would approve what our plan was going to be.”

That plan, which was eventually approved by the court, transitioned Chavez into the role of company chairman. Victory Park brought in Hispanic food and grocery industry veteran Javier Ramirez to lead Mi Pueblo as its new president and chief executive officer. Keeping Chavez in the fold was instrumental to Victory Park’s selling the company on the deal.

“We went into this looking to partner with management,” says Carroll. “It’s very hard to convince investors to trust you with capital to manage in a business like ours. But what’s harder, and what’s just as or more important, is to get that CEO to trust you to take your capital.

“We’re not in there to steal their business. We’re not in there to pull the rug out from under them. We’re in there to work with them and partner with them.”

It’s a sentiment that extends to all of Victory Park’s portfolio companies, Carroll says. It certainly won over Jonathan Reich, whose distressed corporate services firm Reich Brothers Holdings was backed by Victory Park last year after a mutual acquaintance introduced him to the firm.

“We are approaching our one year anniversary, give or take,” says Reich, adding that he feels as though he is on equal footing with the firm. “They’ve provided us with everything from capital to complete our deals and to grow… as well as, in effect, a sounding board.”

THE ASCENT

Although the VPC partners are quick to assert that the firm’s strategy is not “loan-to-own”, their track record demonstrates a willingness to step in to take over a business when necessary.

Take Ascent Aviation Services, a Tucson, Arizona-based airplane repair company that Longuevue Capital acquired from Victory Park last year. Ascent was one of the firm’s earliest deals. Victory Park provided a senior secured loan to what was then known as Global Aircraft Solutions in 2007.

“[We] provided them with a 12 month bridge loan. That bridge loan was secured by aircraft, engines and parts, so effectively we had the downside protection through the metal, and if they paid us off on the bridge loan, the economics were excellent. If they didn’t, we were prepared to take it over and rebuild the business, reposition it for future growth,” says founding partner Matthew Ray.
When the company failed to pay back the bridge loan – it filed for bankruptcy protection in January 2009 – Victory Park provided a DIP loan to finance the bankruptcy process. After it emerged from bankruptcy, the firm set about rebooting and rebranding the airplane repair shop.

“The lead up, that’s really where the work’s done. While we were a lender, we were learning about this business and doing our homework. In that 12-month period, we were closing that information gap, where there’s risk in these deals,” says Levy. “We really had two choices at that point: liquidate and just get our money back, or is there an opportunity build the business?”
They opted for the latter option.
“We shut the business down and rebuilt [it] from scratch. Opened it back up in March of 2010 as Ascent,” says Ray. “New management team, new safety systems, new quality systems, new ERP backbone, new customers. Soup to nuts, you know – a full, deep operational turnaround.”

The restructuring included a complete overhaul of the Ascent hangar’s quality and safety systems, which were overseen by the Ascent’s new management led by Ray, who acted as interim CEO and chairman of the company. Improvements were also made to the company’s production processes, installing digital screens that tracked inputs to individual tasks, accounting for how many man-hours and materials would be required for completion.

The repair work allowed the business to pursue contracts with higher tier customers, says Ray. After rebuilding Ascent’s customer base, Victory Park determined that it was ready to exit the business.

“From that point forward the business executed fairly well,” Ray says. “The only thing holding it back was growth. There was only one hangar, so what we did in order to maximize the value at exit was work with the Tucson airport and got approval for another hangar on a site.

“We sold it to a lower mid-market sponsor – Longuevue – and, other than the fact that Mi Pueblo hasn’t unfolded completely, it’s very similar to Mi Pueblo,” he adds.

A MATTER OF TIMING

Victory Park’s belief that the aviation industry was facing an imminent downturn led to their investment in Ascent (it also acquired Gulfstream International Airlines, which it rebranded as Silver Airways). Similarly, the appeal of a growing Hispanic market had appealed to the firm long before the Mi Pueblo opportunity emerged.

“Maybe it’s not the smartest thing to say, but it’s better to be lucky than good in our business, and if you time the cycle, you’re going to look a helluva lot smarter than the smart guy who misses the cycle,” said Levy. “And we got really lucky, because we timed the cycle to perfection.”

Levy, Carroll and Ray left asset management firm Magnetar Capital to launch Victory Park in 2007. They announced a critical strategic partnership with FRM Capital Advisors, a division of Financial Risk Management, in August 2008, only a month before the collapse of Lehman Brothers transformed the “credit crunch” into a fully-fledged crisis.

“We saw a pretty frothy market. It’s easy to say in hindsight, but people were not assessing risk properly,” says Levy. “Deals were being done that didn’t even come close to matching the risks people were taking. Historically, that ends badly and, like I said, it’s easy to say in hindsight because it did end very badly.”

It was a similar environment to what the firm is seeing in the market today, Levy continues: “Deals that we would never do are getting done again. That doesn’t mean they won’t work out well, but that’s just not our DNA. There’s not a lot of downside protection in those situations. For good or for bad, we’re back to that kind of PIK-light, mispricing of risk. How long it lasts, I couldn’t tell you, but it feels far more like 2006 than it does 2009.”

As Victory Park plots its next move – the firm will consider launching businesses that are “one step out” from their core competency, says chief operating officer Jordan Allen [see ‘Building out’] – maintaining that sense of timing, which allows the firm to outsmart the smart guys, will facilitate the continued growth of the firm, eventually allowing it to provide the services that smaller banks were known for in the years leading up to the crisis, the team says.

And with that, Private Debt Investor’s time with the Victory Park Capital is up. When asked about where to find a good lunch, a place to begin writing, the team doesn’t hesitate.

“You should go to Giordano’s,” says Levy. “It’s right downstairs.”