Spotlight on Toys R Us's CVA

By Paul Norman - Thursday, December 07, 2017 10:35

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A combination of store closures, a move to monthly rents, rental cuts and store downsizing proposed in Monday’s Toys R Us CVA will, if accepted by creditors, likely lead the loan behind the UK’s first secondary commercial property portfolio to return to European securitisation markets in the wake of the global financial crisis to be placed into special servicing next year, report Deutsche Bank research analysts in a wide-ranging review of the process.

On Monday Toys R Us confirmed reports that it would close a minimum of 26 of its 84 permanent stores, with seven of the 30 stores in the Debussy Toys R Us CMBS among those proposed for closure, and a number of others slated for downsizing and rent reductions.

In a statement Toys R Us UK said it was announcing a plan to “transform the business to meet the evolving needs of customers in today’s UK retail market. By instigating a Company Voluntary Arrangement (CVA), the company will seek creditor approval to reposition its real estate portfolio for future growth and profitability”.

It added: “There will be no disruption for customers shopping through the Christmas and New Year period. During 2018, the proposed plan will entail changes to the store estate as it moves to a new and exciting business model.”

Under the CVA process, Toys R Us UK has submitted a “comprehensive operational and financial restructuring plan to its creditors and will solicit their approval of this plan over the next 17 days”.

If approved by the creditors, the CVA plan would substantially reduce the UK company’s rental obligations and allow the business to move to a "new, viable business model". The process, it said, is likely to involve the closure of at least 26 stores. The company intends to commence store closures in spring 2018.

The business employs 3,200 people, and as part of the CVA process, it anticipates a requirement to make redundancies. “All efforts will be made to redeploy team members where possible”.

A detailed CVA proposal document (with voting procedures) was made available to creditors securely via a dedicated website page at: https://ips-docs.com and other interested parties can view the proposal at: www.toysrusinc.com/cvaprocess. The creditors will vote on the CVA on 21 December 2017.

Alvarez & Marsal is serving as restructuring advisor to Toys R Us UK and Kirkland & Ellis is serving as principal legal counsel to the company.

The UK business of Toys R Us is funded in particular at the property company level via the £263m sale-and-leaseback Debussy CMBS.

In July 2013 Toys R Us priced and closed the securitisation of 31 UK-wide retail stores and a distribution centre, as PIMCO and Marathon Asset Management converted their £263.16m bridge loan into seven-year Debussy DTC CMBS notes at par.

CoStar News reported that PIMCO had acquired the entire £184.2m class As and £52.6m class Bs, while Marathon had taken the majority of the £26.3m class Cs – all less a vertical 5% retention by Toys R Us, in compliance with the post-crisis EU 5% Capital Requirements Directive (CRD) for banks and investment firms.

Toys R Us, jointly-owned by Bain Capital Partners, Kohlberg Kravis Roberts & Co and Vornado Realty Trust, had refinanced the Vanwall Finance CMBS on 28 March and that converted at the fixed rates: 5.93% for the class As; 8.25% for the class Bs and; 10.5% for the class Cs.

Debussy CMBS was the first non-bank structured European CMBS, arranged by Cairn Capital, agreed between capital market investors, PIMCO and Marathon, and the borrower Toys R Us direct, with no bank in the middle. It was also the first European CMBS which, at issuance, did not include a AAA tranche, with the secondary quality of the portfolio such that the most senior rating was A-, by Standard & Poor’s, and BBB-low, by DBRS.

At the time, Situs, which was appointed servicer and special servicer, said the transaction represented the first secondary commercial property portfolio to return to European securitisation markets since the global financial crisis and suggested it could kick-start the financing of other challenging asset classes, and showed an evident recovery in the European securitisation markets.

The 1.87m sq ft Toys R Us portfolio was of secondary quality, owned within an opco-propco structure delivering an annual passing rent of £23.0m, comprising 30 retail stores and a distribution centre in Coventry collectively valued at £315m, according to the 2013 20 March-dated valuation by CBRE. The vacant possession value was 38% lower, at £194.51m.

The Coventry distribution centre was the highest valued asset, at £42.5m, with the remaining portfolio valued at between £3.2m and £17.5m.

Every asset had a 30-year occupational lease, maturing in February 2036, except one lease which expired February 2037. All leases were subject to five-yearly upward-only rent reviews.

The Debussy CMBS matures in July 2020, with a five-year tail period to the legal final maturity in July 2025. Beneath the CMBS were £80.2m in subordinated intercompany loans.

The CVA

Deutsche Bank research analyst calculations from Paul Heaton and Connor O’Toole find that the store closures alone would not be enough to push the loan into Special Servicing but combined with three other CVA components - the move to monthly rents, rental cuts in the remaining estate and likely some store downsizing - the “loan will default on its interest payments and likely move to Special Servicing in the middle of 2018”.

Focusing on the CMBS structure Deutsche says that the closure of the seven stores within it will eliminate circa £4.1m of rent or circa 17% of the rent roll. Stores slated for closure in the CVA are noted as category 5.

Alongside the 26 store closures which relate tthere are three further categories – 2, 3 and 4 – which will see either a reduction in footprint occupied by the retailer or will see a reduction in rent.

The reduction in footprint would be at the landlord's discretion, but the CVA allows the company to terminate thes leases with 45 days.

Toys R Us is aiming to refocus on store sizes in the range of 20,000-25,000 sq ft range which, as Deutsche Bank points out, would roughly equate to splitting the retail warehouses in two and “requiring partition walls, new entrances, potential planning consents”.

It estimates that if all stores slated for downsizing were to be halved in size, the total rent of the portfolio would fall 60% to £10m.

It adds: “If the landlord did not agree to the downsizing, and no stores were vacated, we calculate rental income would fall to £14.5m” but says the endpoint is “likely to be closer to the £10m figure than the £14m one”.

At a £10m level of income, the Class B and C in Debussy would not receive interest (save the reserve paying 50bps for the latter).

Deutsche adds that Toys R Us’s CVA proposal that it pays rent monthly in advance, versus quarterly, would deplete the Reserve Fund at the January IPD, and lead to default later in the year when further rent reductions begin.

It writes: “We think whether it is in April, July or October is dependent on the speed of any downsizing of stores - but we calculate that it is very likely to occur by October at the latest.”

Reviewing the CVA and its impact on the CMBS Deutsche writes: “We have long worried, the operational leverage in the Toys R US OpCo via the rents and store costs weighed on its profitability (or lack of) and made the PropCo Debussy debt unsustainable. While the CVA seems to address the former at the expense of the latter, we still worry it is a case of running to standstill given intense competition in the area - we recall the sports retailer JJB entered into CVAs in 2009 and 2011, before going into administration in 2012.

“With events playing out as we envisaged in our earlier analyses we maintain the Class A is at risk of a loss in the region of mid single digits (vs par). We understand current trading volumes are limited, with the A last indicatively pricing in the mid 90s in September post the US entity entering Chapter 11. For the Bs (again thinly traded indicative levels in the 80s in September) and Cs (50 area last September) - given we think coupons will be cut-off from mid 2018, we would only consider buying at levels in the mid-single digits. However, any pricing pressure for the A taking levels into the 80s, perhaps provoked by potential rating action taking the rating to non IG, we think could prove an interesting opportunity - the Vacant Possession Valuation of £196m we think provides cushion against deterioration versus the mid single digit % losses we have historically - and continue - to project.”

pnorman@costar.co.uk

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