Forgive my sarcasm, but my favourite nearly insolvent REIT, Holloway Lodging REIT (TSX: HLR.UN) announced their latest quarterly results. They weren’t that bad relative to the previous year, but the company has a huge debt anchor around its throat while it is being asked to swim across the Pacific Ocean.
More specifically, in order to pay off an earlier debenture, the company through a related entity, borrowed money at double-digit rates of interest and continues to have about $12M outstanding at this time through that loan. There is another debenture maturing in less than 8 months worth approximately $50M face value that they admitted they won’t be able to pay off when it becomes due.
The likely scenario is that they will be doing a debt-for-equity swap. However, there is a game of “chicken” being played – there could also be a chance that the controlling shareholder would float another bridge loan to the company and pay off the debenture to avoid massive dilution – similar to what happened with the first debenture.
This is the only reason why I can think that the debenture has a bid at 50 cents on the dollar. Even with this debt anchor removed, the underlying operations are not all that profitable – most of the profit is being sucked off by the controlling shareholder through related entities.
OK Sasha. I think you are baiting me here. You are light on the facts and too easily blow off some tangible inter-relationships. My disclaimer: I own HLR.DB.B debentures (the ones maturing in June 2012) but have no affiliation to the company or any of the parties mentioned below).
Firstly, the related party providing the “double digit” financing is Geosam Investments -controlled by George Armoyan. The interest rate is 12.5%, high but not usurious.
George Armoyan has the following holdings, as of today: Options 120,000, Trust Units 1,761,667, Warrants 1,050,000. Michael Rapps (Managing Director at Geosam) has 80,000 units. Royal Host REIT owns 6.251 million units (Armoyan has a major interest in Royal Host as does Clarke Inc. which itself is an Armoyan investment vehicle).
I think you are skittering right over the main story here. This is an Armoyan fixer-upper. He needs to fix it since it affects his holdings all the way up to Clarke Inc. He is personally on the Board and Rapps is Chair. They stand to gain significantly if they can repair the balance sheet of HLR.
Debt for equity is an option but is not likely in my opinion. The following options are outlined in the recent release:
1. Repaying a portion of the principal amount of Debentures, including by disposing of one or more hotel properties. At thepresent time, 11 of the REIT’s 20 hotels are financed by mortgages that are part of commercial mortgage backedsecurities pools; the REIT does not intend to dispose of any of these hotels at the present time due to the terms and conditions of such mortgages. To the extent the REIT disposes of any of its hotels or other assets, it is required, pursuant to the terms of its secured credit facility, to apply at least 75% of the net proceeds resulting from such dispositions to the repayment of amounts outstanding under such facility;
2. Refinancing all or a portion of the principal amount of Debentures;
3. Pursuing an extension of the maturity date of the Debentures;
4. Reducing the principal amount of Debentures outstanding prior to maturity through normal course issuer bids and/or other permitted purchases;
5. Satisfying all or a portion of the principal amount of the Debentures at maturity, or redeeming all or a portion of the principal amount of the Debentures prior to maturity, by issuing trust units to holders of Debenturesrather than paying cash;
6. Combinations of the above options.
I think it goes like this – options 1 and 4 are maxed out. (Holloway already acquired and wiped out $1.6M of debentures in October alone). Then either additional funds are advanced by a Geosam-led consortium (#2) or an extension offer is made (probably with a higher interest rate and/or improved conversion option) for the debentures. I think debt to equity is by far the worst option for insiders, so it will not happen.
I also think you are being too harsh on the underlying fundamentals. Their properties are in western Canada primarily and hotel industry stats are improving there.
At $63 (recent price) the 2012 debentures have a YTM north of 90%.
I agree about the fixer-upper concept. I think we disagree about whether the public can benefit with this on side with Armoyan/Geosam.
The 12.5% loan to pay off the 2011 debentures is secured by second and third liens on 11 properties (as per your point above), so Geosam is safe even if HLR goes belly-up with that loan.
Yes, they do own considerable equity via related entities, but I bet Royal Host’s cost basis on their HLR investment is considerably higher, although they’d be looking for a way to utilize those capital losses.
The cash they have to pay out the 2012 debentures is extremely limited and solely depends on how much Geosam loans to HLR. The rate is prohibitive for any refinancing – who in their right mind would loan money to HLR on an unsecured basis? Even with security (albeit second and third liens) the rate is 12.5%.
I agree year-to-year the metrics are improving.
I also will agree that the company can avoid CCAA simply by converting the debentures to equity and once that debt is converted the ~$3M/year interest bite that will be removed will at least render the company solvent. Just that I don’t think there is a good way to take advantage of this, even by purchasing the debentures. You’re playing a game of chicken with Armoyan/Geosam – will they float the cash to pay off the debentures is the big question.
A small thought experiment – imagine that I buy HLR.DB.B series debentures today at $60. The worst outcome (assuming that the base business does not degrade) is that these are paid out in units in June 2012 instead of as cash. These new units would be priced by the market prior to the conversion and would reflect the post-conversion expectation of fully diluted value. So at the beginning of the first day of trading, post-conversion, previous equity holders would hold units at a diluted value and would not be pleased. New unit holders (the previous debenture holders) would be whole. The company would be solvent. There may be a rush to dump units thus depressing price for a time but a longer term investor can wait it out. I don’t see 60 cents on the dollar as a realistic longer term outcome.
Now an institutional buyer or money manager with large client portfolio holdings can’t play this game because they can’t buy the existing debentures at scale without affecting the price. The smaller independent investor looking for investments measured in tens of thousands can.
I believe that this is the fundamental reason that investments like this are not discussed in the media. No meaningful institutional money can be made and most retail investors will not or can not do the homework required.
You are one of the very rare sources of investment commentary of real use to thoughtful independent investors! Keep it up.
I agree that buying HLR.UN is probably a loser proposition. Also, I agree that HLR.UN’s main purpose today is to enrich Armoyan, keep feeding Pacrim management fees and, probably lastly, to house guests at its hotels. I just don’t agree that there is no way for others to make money on it.
Lastly – do you think it makes sense for Royal Host to take out Holloway?
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I am assuming you are talking about HLR.DB.A and not “B” which doesn’t exist (yet).
There will be so much dilution of the equity from a conversion that I can’t see the debentures retaining anywhere close to par value after such an event. The only way to game this would be to manipulate the unit price to get a better conversion fraction, but anybody left with HLR.UN will be more than happy to ditch it at 50 cents a piece. Even at 50 cents (technically 52.6 cents) HLR unitholders will face about 73% dilution.
Arctic Glacier was a good example of what happens when you get a massively dilutive debenture conversion – that said, there were other circumstances that make them different (they had a bunch of other debt dragging them down, while HLR just has their expensive secured credit facility via Geosam and mortgage debt).
Operationally assume that Q4 has breakeven distributable income, which means annually the entity is pulling in $2M DI, add another $3M that you don’t have to pay in debentures, leaving a $5M/year DI entity. Slap on a PE of 10, assume debenture conversion at 20 cents and you’re left with a unit value still quite south of where the units are actively trading.
Maybe you will get lucky with the debentures and Geosam will bail you out, but I don’t see enough security in the assets to possibly justify it. The risk/reward seems quite poor.
It would make some sense for RYL to take out HLR, but only after HLR gets rid of its debentures. RYL would be compelled to offer 100 or 101 on them if they did it now, which would obviously not happen. Unitholders would get a pittance via a small equity stake in RYL.
Thank you for your kind notes. We can at least disagree with each other without getting into personal attacks unlike that PBN fan.
Yes. Sorry – I do mean HLR.DB.A. Note: I also own RYL.DB.B (which Armoyan is accumulating currently) as well as a variety of other debentures so I regularly mix up my symbols.
Just a few more things – politely of course š
– Arctic Glacier is an interesting test case. Conversion was in July at 29 cents. They are currently trading at 6 cents which puts the original debenture holders at about 20% of face value. If the Holloway A series is converted in 2012 to units and the behave like AG (highly unlikely), this represents a haircut of 66% from the current pricing ($60). So using AG as a maximum downside, debenture purchasers today get reasonable odds of full repayment (or improved debenture terms in a extension offer) for a gain of 66% ($100 face vs $60 purchase) plus interest (almost 11%) versus the risk a principal haircut of 66% with continued ownership in a mildly profitable REIT.
– AG is an extreme outcome. I am not convinced that the market could not effectively discount the unit price prior to conversion, leaving debenture holders reasonably whole. I’m confused by your statement that there “will be so much dilution of the equity from a conversion that I canāt see the debentures retaining anywhere close to par value”. The massive dilution will hurt existing unit holders for sure but if the market effectively prices the effects of dilution prior to conversion then debenture holders don’t have to get whacked. My key bet is that current debenture pricing is much lower than the loss of face value through conversion.
– About Armoyan. I don’t see his MO as trying to bilk debenture holders. He is about ridding companies of ineffective management to unlock value. He has done much already with Holloway and he stands to gain impressively from growing the value of current equity and, conversely, will personally lose if equity is harmed. So I can’t seeing buying the debentures as a “game of chicken” with George. I see it as investing alongside his core thesis, which is a pretty good bet in my books.
Let’s pretend they float a term extension by the debenture holders (HLR.DB.A). What would you accept? A higher coupon? Such an extension would make it unaffordable for the company. Maybe a significantly lower conversion price? 30 cents per unit? That’s almost functionally equivalent to just doing the debt conversion at today’s prices.
Assuming a 60 cent entry, your maximum upside (payout at par) is about a 73% gain (66 2/3% capital, rest of it interest). The downside, again, using AG as an example, would be about 2/3rds as well.
I do agree that AG is an extreme case since they had other debt issues, while HLR just has fairly standard mortgage debt typical for REITs.
I think our key disagreement is summarized by the sentence you wrote:
“The massive dilution will hurt existing unit holders for sure but if the market effectively prices the effects of dilution prior to conversion then debenture holders donāt have to get whacked. My key bet is that current debenture pricing is much lower than the loss of face value through conversion.”
I would highly suspect that if they did a conversion that, in the best case, you’d be able to liquidate the equity at the rate the debentures were trading at near conversion.
I don’t see Armoyan’s MO as being to bilk debenture holders. His MO is to siphon as much cash out of HLR into more stable entities he controls and if it so happens that he “fixes” up HLR, then all the more power to him. Think of Kevin O’Leary on “Dragon’s Den”. I just don’t see how the 12.5% secured loan between HLR and Geosam is in alignment at all with debentureholders’ interests.
OK. Let’s go with your pretend scenario. Yes. I would vote to accept and here is why – TIME. The base business is improving and extending the debentures would allow it to continue to heal. Also, if we go back to options given in their recent release (detailed in previous post), HLR.UN will have bought time to:
– continue with asset sales to reduce debt (#1),
– continue with market purchases of discounted debentures for cancellation (#4),
– pursue lower cost debt to replace Geosam’s emergency funding.
Regarding our key disagreement (you nailed it), note that “the REIT has the option to repay the principal amount of the 6.5% debentures, in whole or in part, at maturity, or to redeem the debentures, in whole or in part, at or prior to maturity, by issuing the number of units calculated by dividing the aggregate principal amount of convertible debentures outstanding by 95% of the ācurrent market priceā (as defined in the trust indenture) of the units on the maturity date.”
The “current market price” prior to the conversion will be a function of the market’s perception of the enterprise value of the post-conversion entity (similar to your analysis previously) prorated to the equity contributions of the converting debenture holders (dominant) and existing unit holders. This is my primary disagreement with you as I don’t understand why you give little credit to the market’s ability to price this correctly. I think the calculation will be fairly straightforward (unlike with AG.UN). If the market prices it perfectly (hahahaha), debenture holders would retain 95% of face value as equity in the go forward company.
I think we have exhausted this topic. Suffice to say, I am very curious as to how this debt situation is going to resolve with HLR. My best wishes for a payback at par for you, but I will most certainly be sitting on the sidelines watching!