Looking under the hood: The First Brands bankruptcy

Blind spots & foggy windshields: How lenders missed first brands’ off-balance sheet debt

Lenders likely overlooked important warning signs due to a combination of factors including:

― Aggressive debt-driven acquisitions: the company’s growth strategy involved significant debt-financed acquisitions, which appear to have not been scrutinized thoroughly

― Off balance sheet financing: First Brands used factoring, a working capital financing option tied to accounts receivable, and other off balance sheet financing methods, which allowed them to accumulate billions in obligations. While these types of arrangements are permissible, lenders appear to have underestimated the risks they posed given the company’s poor and potentially misleading disclosure

― Lack of transparency: the company’s extensive use of off-balance sheet financing created a distorted picture of its financial health, making it difficult for lenders to assess the company’s true financial position

― Interest rates: some of the company’s off-balance sheet financing arrangements carried interest rates >30%, which should have raised concerns among lenders but appear to have not been identified as the borrowing entities were not familiar to the syndicated term loan market

The outcome of this situation is highly unpredictable and will depend on the extent of the bankruptcy, litigation and criminal investigations amid the restructuring process.

― Some lenders may lose their investments entirely, especially those outside of the ad-hoc group that participated in the new-money debtor-in-possession (DIP) facility

― A key variable will include how the working capital financing entities are treated in terms of priority in the recovery value waterfall

― There will be extensive litigation with multiple classes of lenders, especially those who can claim their collateral was double-pledged. This adds a high degree of uncertainty to the ultimate outcome

― Finally, the DOJ has initiated a criminal investigation into the matter, which further clouds potential outcomes

One likely outcome: ad-hoc group members will likely have to fund an additional DIP facility given the company’s expected cash burn over the next several quarters. This would further impair recovery to existing lenders.

OHA’s Rigorous Investment Process

OHA has zero exposure to First Brands across its platform, having consistently passed on every financing by the company that it reviewed despite seemingly enticing pricing. The decision was driven by a series of red flags that made the risk unacceptable. Chief among them were:

― Concerns about governance and ownership, raising serious questions about oversight and accountability

― The company’s reported earnings were questionable, with earnings before interest, taxes, depreciation and amortization (EBITDA) padded by an excessive number of addbacks

― The quality of First Brands’ recent mergers & acquisitions (M&A) activity was puzzling, as it had a pattern of rolling up underperforming businesses and claiming outsized synergies, which posed significant integration risks

― The company’s heavy reliance on international manufacturing added another layer of complexity and exposure, exacerbated by recent tariff policy, that OHA was unwilling to accept

Overall, this situation highlights the importance of underwriting and structuring processes to drive ultimate investment outcomes. OHA believes that a key driver of success in private credit investing is the ability to limit credit mistakes and preserve capital.

Accordingly, a focus on risk management has been a core tenet of OHA’s investment process since inception.

― OHA employs a rigorous due diligence process leveraging the firm’s full capabilities and resources. The depth and continuity of OHA’s industry coverage is the foundation of this process. This team design offers opportunities to leverage proprietary insights from underwriting and investing in competitors and companies in the same industry ecosystem over time. This process benefits from OHA’s frequently advantaged access to borrowers and sponsors from its experience and reputation as a trusted financing partner and incumbent lender in private and syndicated markets.

― OHA is actively involved in structuring and negotiates pricing, covenants and other terms directly with the sponsor and/or company. Industry teams work alongside our in-house documentation experts to ensure we are securing the protections we require for completed investments. Every investment memo contains a detailed documentation review which is discussed in depth with the Investment Committee. If the team is unable to negotiate changes to weaker documentation relative to OHA’s high standards, OHA may decline the investment on that basis.