Welcome to the 102nd Pari Passu newsletter. 

Two weeks ago, we celebrated the 100th edition and covered the out-of-court restructuring of Pluralsight, a fascinating blend of private equity turned ugly. Today, we are back with another great restructuring story: Hertz Corporation. 

Incorporated in 1976 and successor to businesses engaged in vehicle rental and leasing as far back as 1918, Hertz is a long-time market leader in the vehicle rental and leasing space. However, with COVID-19 bringing global travel to a standstill, Hertz crashed into bankruptcy court nearly overnight as one of the largest Chapter 11 filings in history. Uproar ensued as Hertz daringly motioned to issue $1bn of equity post-bankruptcy filing in an attempt to take advantage of their inflated stock price.

While experts initially ridiculed equity holders for pumping bankrupt Hertz stock price to over $5 per share, to everyone’s surprise, equity holders experienced positive recoveries of up to $8 per share as sponsors entered a bidding war in attempts to capitalize on Hertz’s business recovery. Creditors, with 100% principal recovery but no interest, subsequently sued on the basis of “absolute priority,” arguing that debt must be paid in full before equity payout. This article explores Hertz’s abrupt pandemic-driven bankruptcy, audacious equity raise, and the legal complications of “make-whole” fees for disgruntled creditors.

It’s a bumpy road through Chapter 11, so buckle in for the ride. [1] Read through the end for yet another resource from the Pari Passu Newsletter!

But first, a word from Daloopa

Earnings season is wrapping up, and it’s time to set your sights on driving alpha for the next quarter.

Transform your earnings workflow. Tired of the earnings season scramble? Daloopa delivers real-time, clean data for your models so you can focus on high-impact decisions.

Business Overview

Hertz is among the largest vehicle rental companies worldwide, operating globally across the value spectrum through three main brands: Hertz, Dollar, and Thrifty. 

The company reports in two segments: 

• US Rent-A-Car (US RAC): vehicle rentals and value-added services.

• International Rent-A-Car (International RAC): International rental and leasing of vehicles and value-added services. Franchisees and partners operate rental locations in 160 countries. 

It is important to note upfront that Hertz’s business is extremely sensitive to air traffic. Airport revenues comprised ~65% of Hertz’s worldwide vehicle rental revenues in 2019, now up to 66% in 2023.

Hertz’s business model can be summarized into four stages: [1][2]

1. Enters Contracts: Hertz vehicles can be divided into “program” and “non-program” vehicles. Program vehicles are purchased under programs where manufacturers agree to repurchase vehicles at a specified price or guarantee a depreciation rate. While programs limit residual value risk and reduce depreciation variability, acquisition cost is higher. Non-program vehicles are directly purchased from manufacturers or auctions. 

2. Holds Assets: In 2019, the average holding period for a rental vehicle was 18 months in the U.S. and 12 months internationally. In 2023, the average holding period was 20 months in the U.S. and 16 months in international. Historically, holding periods range from 6 to 36 months. Holding periods are relatively short as excessive mileage drastically reduces used car values.

3. Incurs Debt: Purchases of vehicles are financed by borrowing programs and cash from operations. Hertz relies on asset-backed and asset-based financing, and substantially all of Hertz’s revenue-earning vehicles and related assets are owned by special purpose entities (SPEs) and encumbered under various credit facilities, other secured financings, and asset-backed securities programs.

4. Salvages Residual Value: Post-holding period, Hertz disposes of vehicles and recoups residual value through Hertz Car Sales, Rent2Buy, auctions, brokered sales, and sales to wholesalers and dealers.

On a broad level, Hertz is a leveraged spread business, earning the difference between the cost of acquiring/leasing a vehicle and the return from the holding period and vehicle disposal. Thus, the topline is extremely dependent on how much value Hertz can extract during the holding period—a measure vulnerable to macro shock. As the 2019 10K states for the very first risk: 

“The vehicle rental industry is particularly affected by reductions in business and leisure travel, especially with respect to levels of airline passenger traffic. Reductions in levels of air travel, whether caused by general economic conditions, airfare increases (e.g., capacity reductions or increases in fuel costs borne by commercial airlines) or other events (e.g., work stoppages, military conflicts, terrorist incidents, natural disasters, epidemic diseases, or the response of governments to any of these events) could materially adversely affect us.” [1]

COVID-Era Decline

Even before the COVID-19 pandemic shut down global travel, Hertz was experiencing headwinds. In Q1 2017, Hertz shares fell 18% as quarterly losses nearly doubled street estimates. U.S. used-car values and rental prices fell, reducing both holding period return and salvaged residual value which, in turn, narrowed spreads. With increasing competition from Uber, Lyft, GM, and Turo, Hertz was already on the road to trouble. [3]

However, it wasn’t until COVID-19 hit that Hertz crashed. It should be noted that Hertz was not truly facing financial distress prior to the pandemic, and without the pandemic, bankruptcy was unlikely. However, the fragile nature of Hertz’s business model made the business uniquely vulnerable to “black swan” events. When COVID-19 tanked both rental demand and used vehicle value, both Hertz’s topline and margins were decimated. 

Reduced Rental Demand

When the pandemic grounded airlines, approximately 65% of Hertz’s operations were shut down by proxy. We can see the impact of the lockdown through two key metrics:

1. Total Revenue Per Unit Per Month (Total RPU): Measures revenue productivity relative to the total number of fleet vehicles. From 2019 to 2020, total RPU per month decreased 34%, from $1062 to $697. 

2. Vehicle Utilization: Measures the proportion of vehicles used to generate revenues relative to fleet capacity. From 2019 to 2020, vehicle utilization fell from 80% to 53%. [1] [4]

Reduced Used Vehicle Value

Used vehicle value is crucial in determining a company’s vehicle expense through the following formula:

Purchase price - Recovery value at disposition = Vehicle cost

Reduced residual value increases vehicle expenses and depreciation therefore contracting margins. With depreciation of revenue-earning vehicles and lease charges as 26% of sales in 2019 and direct vehicle and operating expense as 56% of sales, operating margin was in the single digits even prior to COVID-19. When used-vehicle prices took a nose-dive at the beginning of the pandemic, operating margins dipped near -80%. [1] [5]

To add fuel to the fire, Hertz was highly leveraged prior to the pandemic with barely enough income to pay interest. To do some quick math to illustrate its precarious position, we can compare its debt and operating income. The company had non-vehicle debt of $4.4bn and vehicle debt of $12bn for a total debt-load of over $16.4bn (their leverage hovered around 5x, high for a public company). Vehicle loans are financed pretty efficiently so we can take a 4% average interest rate on the debt which implies ~$600mm in yearly interest. Comparing this with the average operating income of ~$700mm in the yearly leading up to the pandemic, we can see they were not exactly printing cash. Therefore, as the pandemic spread and earnings dropped, the case was immediately in huge need of cash.

By March 31st, 2020, Hertz had approximately $2.5bn of vehicle debt and $19mm of non-vehicle debt maturing within the next 12 months. As the Q1 2020 10Q states: 

“The Company has reviewed its debt facilities and determined that the Company may not be able to repay or refinance these facilities prior to their respective maturities due to the impact from COVID-19.” [6]

Almost overnight, Hertz could no longer service its debt load. However, to better understand how this led to bankruptcy, we must examine Hertz’s financing structure.

Financing Structure

At first glance, Hertz is broadly structured as a HoldCo/OpCo structure, with Hertz Global Holdings owning the operating company Hertz Corporation through Rental Car Intermediate Holdings, LLC.

Though complex, Matt Levine clarifies Hertz’s financing structure in Bloomberg’s Money Stuff: [7]

“Hertz finances its cars using asset-based securities: An entity called Hertz Vehicle Financing LLC buys cars and leases them to Hertz, and HVF gets the money to buy the cars from an entity called Hertz Vehicle Financing II LP, and HVF II gets the money by selling securities (backed by cars and the lease payments) to investors.”

Crucially, the lease payment that Hertz makes to HVF is variable and increases as the value of the used cars in Hertz’s fleet decreases. This is exactly what happened during COVID-19, where vehicle values plummeted 11.4% from March to April, from 155 to 137. [28]

Consequently, the borrowing base of asset-backed notes decreased, which required Hertz to make additional payments to offset the value declines in order to continue using the vehicles—essentially a margin call. As the 2019 10K warned: [1] [6]

“If disposal of vehicles in the used vehicle marketplace were to become severely limited at a time when required collateral levels were rising and as a result we failed to meet the minimum required collateral levels, the principal under our asset-backed and certain asset-based financing arrangements may be required to be repaid sooner than anticipated with vehicle disposition proceeds and lease payments we make to our special purpose financing subsidiaries. If that were to occur, the holders of our asset-backed and certain asset-based debt may have the ability to exercise their right to direct the trustee or other secured party to foreclose on and sell vehicles to generate proceeds sufficient to repay such debt.”

Capital Structure 

Hertz’s capital structure was hefty prior to filing. Debt is divided into non-vehicle debt and vehicle debt specifically tied to the purchase, leasing, or financing of Hertz’s fleet. [6]

An important note for later: senior notes from non-vehicle debt are comprised of four issues.

Out of Court Restructuring

By March 2020 with COVID-19 in full swing, Hertz dove into liquidity management mode by: [6][8] 

1. Canceling remaining 2020 US rental fleet orders by leveraging multiple used-vehicle channels and negotiating with suppliers to reduce fleet commitments. Hertz reported an expected $4bn in reduction in US RAC vehicle purchase commitments.

2. Accelerating global dispositions of risk vehicles and vehicle sales.

3. Suspending 20,000 employees worldwide, 10,000 of which were later fired in April.

4. Stretching payables by negotiating to abate or defer airport rent and concession payments.

5. Eliminating non-essential spending by reducing capital expenditures and eliminating discretionary marketing spend. 

6. Drawing down their senior revolving credit facility. As of March 31st, Hertz’s unrestricted cash and cash equivalents totaled ~$1bn.

Concurrently with the expense management and liquidity measures above, in mid-March, the CEOs of Avis, Hertz, and Enterprise sent a joint letter to the U.S. government requesting that the rental-car industry be included in any economic stimulus package in hopes of receiving tax deferments and reduced revenue-sharing with airports—in other words, a federal bailout. None was forthcoming. Hertz stock was down over 80% to $4—a steeper decline than even shares of the three largest U.S. airlines. [9]

S&P downgraded Hertz two levels to a B-, well outside Fed parameters for buying junk bonds. Credit default swaps implied a 78% chance of default within the next year, and a 100% chance in the next five. Hertz October 2022 bonds were trading at 31, implying a 67% yield. Even the top-rated portion of the most recent deal from HVF maturing 2025 traded on April 8th at 89, down from 102 a mere month earlier. [9] 

During April 2020, Hertz began negotiations with creditors to obtain relief from rent payment obligations under its operating lease agreement. To preserve liquidity during ongoing discussions, Hertz did not make certain payments in accordance with the operating lease agreement on April 27th. This resulted in an amortization event for all series of HVF II notes and a liquidation event for variable funding notes (“Series 2013-A Notes”). Noteholders now held both the power and right to accelerate the liquidation of the collateral fleet. [6]

To stave off liquidation, on May 4th, Hertz entered into a forbearance agreement—effectively a short-term extension on loan payments—with approximately 77% of Series 2013-A Notes. Noteholders agreed to forbear from exercising liquidation until May 22nd, 2020. In return for forbearance, Hertz agreed to a limited payment of $30mm. Hertz also negotiated limited waiver agreements with lenders under the senior RCF, senior TL facility, letter of credit facility, alternative letter of credit facility, and U.S. Vehicle RCF to avoid triggering cross defaults. [6][7]

Management apparently did not have high hopes from forbearance, stating in the Q1 10Q: 

“Management has concluded there is substantial doubt regarding the Company's ability to continue as a going concern within one year from the issuance date of this Quarterly Report on Form 10-Q.” [6]

The market concurred. Bonds maturing in 2022 and 2028 traded at an average of under 10 cents on the dollar on May 4th, down from over 100 cents three months earlier. [10]

Both forbearance and waivers expired on May 22nd. To prevent immediate liquidation, on May 29th, 2020, Hertz and 29 affiliates filed for Chapter 11 in the District of Delaware. From approximately three months of COVID-19 lockdown, Hertz went from an equity value of $8bn to almost nothing (Point 1 in the stock chart below). [7]

Hertz Corporation Stock Price (Bloomberg)

Audacious Moves: Equity Raise over DIP Financing

With approximately $1bn cash after revolver draw-down, Hertz was in no rush to attain DIP financing. However, management and savvy lawyers saw an opportunity for cheap capital amidst bankruptcy, which sounds like an oxymoron. 

In early June 2020, just weeks after filing, Hertz’s stock suddenly rose from $0.56 a share to $5.53 a share (Point 2 in the stock chart above). In other words, the market was valuing the equity of a bankrupt company at $800mn, which while only 6% of their peak 2014 valuation of $14bn, was still irrational for a company where debt was trading less than 10 cents on the dollar. By the absolute priority rule in Bankruptcy Code, higher priority claims must be paid in full before lower priority claims can receive recovery. Debt always has priority over equity in capital structure, so if even debt is trading for nearly nothing—implying little chance of recovery–the equity below them should expect to be completely wiped and thus worth nothing. [9]

Much of Hertz stock’s miraculous recovery was driven by speculative Robinhood trading and the chase for returns as interest rates were slashed and the Fed pumped stimulus checks. Tom Lauria, Hertz’s attorney from White & Case, acknowledged in court that the trading price of Hertz shares was (big surprise) disconnected from fundamentals.

“New platforms for day traders may be facilitating this [disconnect of trading price from fundamentals]... There are forces at work that us non-financial people, that we can only observe.” [11]

Yet, Hertz did much more than merely observe…

Subscribe to Pari Passu Premium to read the rest.