For most people, mattresses are boring, essential household items and selling them is hardly a glamorous business either. You would probably not expect to uncover one of the largest frauds of the past decade studying a mattress firm.
But that’s exactly what hedge fund JHL Capital ended up doing when it got involved with Mattress Firm.
JHL Capital has a record of spotting terrible companies. In 2015, the firm was one of the first to call out the businesses practice of using leverage to roll-up businesses; a strategy made famous by Valeant Pharmaceuticals. And today, the hedge fund is on the lookout for companies that might be impacted by “Quantitative Tightening.”
JHL’s search for attractive short positions led it to Mattress Firm in 2016. According to the firm’s fourth quarter and full year 2017 letter to investors, a copy of which has been reviewed by ValueWalk, the fund was initially attracted to this company as it believed the group was ” effectively destroying capital” and it was only a matter of time before the mattress business breached its debt covenants. JHL’s figures suggested that the stock was worth zero.
Unfortunately, soon after entering the position, Mattress Firm was brought out for a premium of 100% by Steinhoff International Holdings. “We then did due diligence on SNH [Steinhoff], and it’s motivations for what seemed to be a reckless investment” the letter states. Following this review, JHL concluded that the transaction was likely to be “value destroying” for Steinhoff investors and must have been “driven by something non-economic, like a desire to temporarily distract investors from other aspects of their business operations.” JHL positioned itself to short Steinhoff.
Here’s where things get interesting. According to the letter, soon after JHL established its short position, the firm noticed that the European Central Bank was buying a substantial amount of Steinhoff Europe AG’s debt as part of its corporate sector purchase programme, part of the overall package of quantitative easing. These purchases, of both existing and new issuance, “effectively provided a negative real cost of capital” to Steinhoff. With the ECB providing Steinhoff Europe AG with a seemingly limitless and free source of liquidity, JHL covered its short position. “How does one assess an apparent financial fraud against the ongoing free money hand out from the ECB” the letter opines.
Under the terms of its corporate sector purchase program, The ECB is allowed to purchase bonds of any company that carries an investment grade rating. In July of last year, Steinhoff Europe AG fell into this bracket so when it issued 800 million of euro-denominated bonds, Europe’s central bank stepped into the market to buy a chunk.
In December of last year, the news broke that the South African based retail giant had uncovered accounting irregularities that stretched back before 2015. On January 2 the company announced that it’s 2017 accounts would be accompanied by restated financials for 2015 and 2016, and that previous figures for those years can “no longer be relied upon.” It also warned accounts for years before 2015 were “likely” to need restating. The full scale of the scandal is not yet apparent. Steinhoff has said the issues relate to the viability of about €6 billion worth of assets on the balance sheet of operations in Europe. These assets, which may or may not exist and may or may not have any economic value, have been funded by €4.8 billion of debt (the group’s total debt is €10.7 billion of which €4.8 billion was in Steinhoff Europe AG as of December.)
Following these developments, the ECB has sold off its debt holdings in the embattled business. According to the Financial Times, the central bank had owned around €100 million of the bonds, which had fallen to a low of 49 cents on the euro according to trading data for the first week of January. These figures suggest that the bank could have taken losses in the region of €50 million on the debt sale. Unlike other holders, the bank has been able to print more money to cover up this damage.
The letter from JHL sums up the situation in a manner which sounds a bit Paul Singeresque:
“The SNH example is a powerful lens through which to view the current market regime. Free or virtually free money is available to private market participants so long as they undertake any risk seeking activity, i.e., doing what the central banks want them to do. In a world where the cost of capital is negative, cash-burning companies may not only survive but thrive.”