Lead Story…. Back in 2004, Sears was purchased by ESL Investments, the hedge fund founded and managed by billionaire Eddie Lampert. The once mighty Sears brand had already begun it’s long decline and Lampert, who already owned struggling big-box retailer KMart was viewed by many in the financial media as a savior. Back then, Lampert had been favorably compared to Warren Buffet for his long term value approach to investing – a comparison that has aged horribly. The rationale for investing in the Kmart/Sears turnaround was this: an investor was getting in on the ground floor with a great value manager and, even if the turnaround failed, there was still upside in the real estate holdings of the company which some believed were more valuable than the operating business. Anyone who follows financial media or, for that matter has been in a Sears store recently knows that this bet has gone horribly wrong.
When Warren Buffett buys a company, he is largely buying it for the management and takes a relatively hands off approach. Lampert instead opted to run Sears as the CEO, and he ran it right into the ground. Put aside, for a moment the pure absurdity of a hedge fund manager becoming the CEO of a discount retailer. My biggest issue with the Sears debacle isn’t that it’s going to fail spectacularly although at this point that’s basically a given. Rather, it’s the incredible misalignment of interest between Lampert and his investors that has only gotten worse as the good ship Sears continues it’s long, slow descent towards the surface. It would stand to reason that Lampert would be losing his ass as the company fell apart. Indeed, his net worth has shrunk from $3.1 billion in 2012 to a meager $2.2 billion today (insert world’s smallest violin here). However, on the way down, Lampert has managed to take steps to shore up his own position, peeling away much of Sears’ most valuable real estate holdings, and positioning himself as the company’s senior creditor, all at the expense of other shareholders. Nathan Bomey of USA Today detailed how he pulled this off (emphasis mine):
Here’s how Lampert has retained assets even as Sears has shriveled:
- Lands’ End: Sears spun off retailer Lands’ End in 2014, but Lampert’s hedge fund owns 59% of the company. That stake was worth nearly $360 million as of Wednesday morning.
- Real estate: Sears sold 235 store properties and its interest in another 31 properties to a newly formed real estate investment trust (REIT) called Seritage Growth Properties for $2.7 billion in 2015. The deal gave Seritage control of some of Sears’ best properties in a sale-leaseback transaction. Lampert’s ESL owns 43.5% of the limited partnership units of Seritage and 7.9% of the REIT’s voting power. The move was similar to transactions favored by investors in legacy retailers whose real estate is considered more valuable than their actual business. The problem is that “then you end up signing leases” and saddling the company with lease liabilities, said Neil Stern, senior partner at retail consulting firm McMillanDoolittle. Sears agreed to pay Seritage $134 million in annual base rent for the first year, with 2% annually increases beginning in the second year.
- Real estate collateral: Entities affiliated with Lampert’s hedge fund extended $500 million in credit to Sears in January, secured by at least 46 Sears properties and possibly more. That means that in the event of bankruptcy, the lender may be awarded the property rights, giving Lampert control of those store sites.
- Additional secured financing: ESL lenders provided Sears up to $500 million through a secured letter of credit facility in December, from which Sears has already drawn $200 million. ESL lenders also hold $336 million in secured debt issued to Sears in April through a separate facility and term loan, as well as $300 million in a second lien term loan issued in September. Secured lenders are paid first in bankruptcy.
- Sears Canada: Sears partially spun off its Canadian division in 2012, but Lampert’s ESL owns about 45% of the company. That stake was worth nearly $80 million as of Wednesday morning.
- Sears Hometown and Outlet Stores: Sears spun off the franchise in 2012, but ESL retains 57% ownership of the company. That stake was worth about $45 million as of Wednesday morning. Also, Sears Hometown and Outlet Stores still acquires “a significant amount of its merchandise” from its former parent company “at cost,” according to a filing. Sears Holdings also provides certain logistics, warehousing, human resources, information technology and transportation costs to Sears Hometown and Outlet Stores, which is invoiced weekly and also pays its former parent royalties on sales of certain brands.
- Paid-off financing: Affiliates of ESL and another Sears investor, Fairholme, made a $400 million short-term loan to Sears in 2014 that has already been paid back in full.
Corporate filings reveal that Lampert, who disclosed in a corporate filing that he owns all of ESL and makes all of its investment decisions, has made moves to protect his position.
“Financially he’s moved a lot of levers that have kept this company going longer than some of us thought it could,” Stern said. But with “some of those levers you’re setting the furniture on fire to keep the house alive.”
The initial playbook for Lampert may very well have been to turn the retailer around. However, when it became apparent that the turnaround wasn’t going to happen, his strategy clearly pivoted to carving off the real estate into insulated entities and becoming the struggling company’s primary secured creditor. Great news for Lampert, who has managed to limit his exposure in a failing venture, bad news for anyone stuck investing with him. IMO, there are two major takeaways here:
- Stick to your Knitting: Just because someone is great at something doesn’t mean that they are great at everything. Lampert was once called the best investor of his generation and had made $1 billion in a single year before purchasing Sears. He is clearly a great hedge fund manager (or at least he was before he got distracted by this debacle). However, the hubris resulting from that success led him to believe that he could be successful running a large retailer whose fortunes had been in decline for years. Clearly that didn’t work out. Same thing applies for developers – if you are a successful industrial developer, it’s probably dangerous to assume that you will also be successful at entitling residential land or building homes. It doesn’t always work that way. Develop a specialty or niche and strive to be the best at it rather than chasing every business opportunity that comes along.
- Assume Nothing: Just because you invest in the same opportunity as a billionaire, don’t assume that you are making the same deal that the billionaire made. Lampert’s investors are finding this out the hard way and will be left holding the bag. Same goes for real estate development and investment. Whether you are a sponsor or investor, make sure that your deal structure aligns interests properly before you commit. It’s a lot less painful to deal with upfront than it is when things go sideways down the road.
Sears is a mess and will continue to close stores, hurting the economy and leaving people unemployed along the way. Lampert will make out just fine. Investors who thought that they were buying into the next great turnaround story with limited downside won’t be. Caveat Emptor.
Feeling the Squeeze: Rising interest rates are eating into retailers bottom lines as consumers remain addicted to 0% financing.
Deep Hole: A visual history of how we ended up with over $1 trillion in student debt from the 1200s at Oxford to today.
End of an Era: The days of large scale, low-skilled immigration might already be over and it has more to do with demographics than politics. See Also: The prime beneficiaries of international immigration are large, coastal urban areas.
Sea Change: Renters now make up a majority in nearly half of US cities. See Also: California has a slew of affordable housing bills on the table but most deal with the symptom (subsidizing affordability) rather than the disease (not enough units being built).
Choke Point: The latest existing home sales report proves that it’s difficult to achieve much in the way of sale volume when there isn’t much for sale.
Secret Weapon: How the humble peanut butter and jelly sandwich – staple of the elementary school lunch box – became the go to pregame snack for NBA teams.
On the Prowl: Silicon Valley cougar bars, where 40-somethings go to try to land a rich tech nerd- are now a thing.
This Will Become a Movie: Meet the finance bro / penny stock scammer who double crossed the FBI while acting as an informant.
Chart of the Day
You Live Where? Check out this comprehensive map of places around the world with lewd names. Examples: there are several countries with a town named Shit and an island off the coast of Australia called Bumbang Island. (h/t Cyndi Deermount – seriously, my mom sent me this so now you know where I get it from)
Serious Dough: Border Patrol agents found $50k in cash hidden inside tortilla dough when a 54-year old Mexican man attempted to cross the border. The man was arrested and the money and tortillas were confiscated. (h/t Michel Faris).
Out of Place: A student from the University of Maine was recently arrested for bringing 5 baby alligators in a taxi. How much do you want to bet this stated during a spring break trip to Florida?
Landmark Links – A candid look at the economy, real estate, and other things sometimes related.
Visit us at Landmarkcapitaladvisors.com