American pet owners are probably all familiar with Chewy, an e-commerce pet food and products supplier that will quickly ship those heavy bags of dog or cat food right to your doorstep at competitive prices. No longer did one of the authors of this article have to walk 30 minutes round trip in the dog days of humid DC summers to pick up and carry a 30 pound bag of Taste of the Wild grain-free high prairie recipe to feed an English bulldog and a French bulldog. Leveraged finance attorneys, investors, lenders and borrowers should also be familiar with Chewy, though for reasons that highlight the complexities and risks associated with today’s leverage finance market.

Pet owners were not the only group fascinated by Chewy and its dominance in the e-commerce space. Long-standing brick-and-mortar pet food and product retailer, a private-equity led investor group acquired PetSmart in a leveraged buyout worth $8.7 billion in 2015. PetSmart’s brick-and-mortar retail offerings were, however, quickly losing market share in the face of the convenience that consumers demand in the e-commerce era. PetSmart targeted Chewy and spent $3.35 billion to acquire Chewy in 2017, funded in part by adding $2 billion to PetSmart’s existing debt load. In June 2019, PetSmart and its investors cashed in on the Chewy acquisition, spinning out the company in an IPO that valued Chewy at $8.77 billion, over 2.5 times what PetSmart paid for the business. But what about the lenders holding over $8.2 billion of PetSmart leveraged debt (plus commitments for a $955 million asset-based revolving credit facility)? Surely they would be able to cash out on the deal? Unfortunately for the lenders, the transaction quickly morphed into a cautionary tale for leveraged bond and Term Loan B investors.

As is common for leveraged facilities of this type, PetSmart, as a borrower, was required to:

  • cause all of its material wholly-owned domestic restricted subsidiaries to provide upstream guarantees,
  • pledge the equity interests of such subsidiaries; and
  • cause such subsidiaries to grant a security interest in substantially all of their assets to secure the PetSmart secured debt.

Accordingly, upon its acquisition by PetSmart, Chewy became a guarantor of the PetSmart secured and unsecured debt and pledged its assets to secure the PetSmart secured debt.

PetSmart continued to struggle financially, causing its senior debt and unsecured debt to trade at reported levels of 80 cents and 50 cents on the dollar, respectively. Nevertheless, the Chewy guarantee and assets provided a sense of comfort to lenders given its ever-increasing market shares, revenue growth and enterprise valuation. However, due to a series of transactions related to Chewy’s equity interests which PetSmart argued were permitted by the terms of PetSmart’s debt agreements, the lenders were soon to find that comfort level significantly eroded.

In June 2018, PetSmart transferred 36.5% of its equity interests in Chewy through the use of available restricted payment and investments baskets under its secured credit facilities. PetSmart transferred 20% by way of a distribution to a holding company owned by its equity investors (none of whom provided credit support for PetSmart’s credit facilities) and contributed 16.5% as an investment to a new wholly-owned subsidiary of PetSmart that was designated as an unrestricted subsidiary. Importantly, PetSmart relied on an “available amount” basket to make the distribution, meaning that PetSmart was able to make distributions in an amount up to the approximately $1 billion of cash contributions that it had received from PetSmart’s equity holders from the period following the initial closing of the PetSmart credit facilities. A third party advisor hired by PetSmart determined the value of the distribution of the equity interests in Chewy to be $908.5 million. Thus PetSmart considered that the distribution was permitted by the terms of its debt agreements because the value of the Chewy equity interests so distributed fell within the available amount basket.

To the chagrin of the lender group, PetSmart’s credit agreement and indentures included an automatic release provision, which effectively provided that if a subsidiary ceased to be wholly-owned by PetSmart, such subsidiary would be automatically released from its guarantee obligations, and any liens granted on the assets of such subsidiary would be terminated. By virtue of the transfers noted in the preceding paragraph, Chewy had become a non-wholly-owned subsidiary of PetSmart. Therefore, PetSmart believed it could in good faith request that the creditors release Chewy from its guarantee obligations and terminate all liens on Chewy’s assets[1].

PetSmart approached the administrative and collateral agent for its credit facilities and asked for a confirmation of a release of the guarantee and liens, but the administrative agent and lenders refused to cooperate. Litigation ensued, with PetSmart’s credit agreement lenders challenging, among other things, the calculations used to value the baskets utilized by PetSmart to effect the transfers and asserting that the transfers and distributions left PetSmart insolvent.

Chewy, in the meantime, continued to rapidly grow, and PetSmart and its equity investors eyed an IPO of Chewy to monetize that growth. In order to clear an IPO, the litigation between PetSmart and its creditors needed to be resolved. After a failed attempt at an amendment to approve the equity transfers, PetSmart was successful in convincing the lenders to agree to such approval, but only after sweetening the terms of a second amendment, including higher interest rates, a consent fee and improved paydown terms. After a large key investor consented, lenders rushed to consent to make sure they were not left without a proverbial “bone”.

With the lenders now presumably consenting to the transfers and the litigation hurdle cleared, the IPO was ready to be unleashed, resulting in an IPO of Chewy on the NYSE in June 2019. At the end of the day, the PetSmart creditors received a paydown from IPO proceeds received by PetSmart (approximately 15% of the term loans were repaid) and PetSmart’s corporate credit rating was upgraded (from CCC to B- by S&P and from Caa1 to B3 by Moody’s).

PetSmart continues to own approximately 67% of Chewy, which, with an implied valuation of $14 billion post-IPO, continues to give PetSmart lenders some collateral coverage due to the value of the portion of Chewy still owned by PetSmart. While some lenders have continued to litigate the Chewy transactions and lender consent process, the situation has mostly stabilized.

Although the Chewy “phantom guarantee” has not garnered the same attention as the J. Crew “trapdoor” (another controversial tactic that used a retail borrower to siphon assets away from secured creditors), creditors are rightly concerned that this scenario could be repeated in other leveraged credits.

From a general review of larger sponsor-backed leveraged credit facilities, our view is that it is common that restricted payment and investment baskets could be utilized to cause a subsidiary to cease to be a wholly-owned subsidiary by either distributing equity interests out of the loan party structure or contributing minority equity interests to unrestricted subsidiaries. Accordingly, such subsidiary would no longer be “wholly-owned” by the borrower under the credit agreement.

However, a silver lining for creditors is that such an action does come with consequences to the borrower. If a subsidiary becomes non-wholly-owned and is no longer a guarantor, the borrower would face tighter restrictions going forward on both making investments into such subsidiary and generally conducting inter-company business with such subsidiary. EBITDA is likely to also be reduced by the amount attributable to the minority interests held in any non-wholly-owned subsidiary. Additionally, as evidenced by PetSmart initially retaining Chewy as a guarantor under its ABL facility, removing a subsidiary as a guarantor will significantly impact a borrower’s borrowing capacity under its ABL facilities since a subsidiary is required to be a borrower or guarantor for the borrower group to receive borrowing base credit for that subsidiary’s assets.

Some law firms and leveraged finance review sites have offered suggested revisions to credit documents to protect creditors against another Chewy incident. While such suggestions are well-intended (and could be necessary in specific instances), it is our opinion that suggestions such as prohibiting dividend and distribution baskets to be used for distributing equity interests will create complications for borrowers and sponsors, and ultimately will not be accepted by sponsors and their portfolio company borrowers.

Rather, in our view, Chewy presents as more of a cautionary tale as to how a borrower can cobble together various baskets to achieve an outcome that creditors may not have expected was possible.

Our advice to lenders and investors in the leveraged loan market is to become familiar with the details of how PetSmart, J. Crew, and others have taken advantage of various baskets, guarantee and collateral requirements and release provisions and to be keenly attentive to similar provisions in their own credit facilities. In the post-J. Crew and Chewy world, lenders must utilize that precedential knowledge to critically and creatively think through all of the various baskets presented in each new credit.

Baskets in the US leveraged market are generally cumulative, meaning, for example, that if a facility contains a $10 million basket for investments in joint ventures and a $50 million general basket available for any investment, a borrower could theoretically invest $60 million in joint ventures. Consideration should be given to how a borrower could put together various baskets to remove subsidiaries, assets or otherwise enter into transactions that are concerning to creditors (and whether there is a rule defining how such basket usage is valued). Following this analysis, creditors must balance those concerns against the safe-guards that exist in the definitive documentation. For example, mandatory prepayment provisions may require a paydown of the debt, minority interests in non-wholly subsidiaries will not count towards consolidated EBITDA and, in the ABL context, lenders can take added comfort in that credit exposure cannot exceed the borrowing base.