Was Hertz’s Bankruptcy And Layoffs Necessary: The Role Securitization Played

Hertz (HTZ), an iconic American company, is laying off thousands of its employees at a time when the federal government has decided to pour billions of dollars into the economy to protect American jobs. Was bankruptcy filing the only option left? Why couldn't Hertz renegotiate its debt with the lenders or access funds from the government to avoid the bankruptcy and layoffs?

A standard narrative is that Hertz just could not compete with Uber and Lyft, as well as other car rental companies that were more agile to adapt to new technology. COVID-19 just hastened the eventual outcome. There is undoubtedly some truth in that argument. But the firm's financial policies have a lot to do with its predicament today. A poorly managed competitive strategy quickly turned into a death sentence for the company due to its mismanaged financial policies.

Hertz has seen several ownership changes and corporate restructuring in its long history, but a key event in 2005 made it particularly vulnerable to an economic shock. This was the year when Ford Motor Company (NYSE:F), the owner of Hertz since 1994, decided to spin it off to a group of private equity investors in a leveraged buyout transaction (LBO). The deal was financed with a heavy dose of debt, as is typical in an LBO transaction. A year later, the private equity group brought Hertz back to the public market as an independent company by listing its IPO under the ticker HTZ. Private equity investors got out with a hefty payout, but the company could never get out of its massive debt burden that the LBO transaction imposed on it.

On December 31, 2019, Hertz had almost 90% debt in its total capital (i.e., debt plus equity combined), compared to an industry average of 45-50%. The company’s debt to total capital ratio has averaged between 90-93% in recent years. Such a high level of debt can make any company vulnerable to product market competition, but Hertz’s problems are notably worse due to the nature of its debt: its debt obligations are predominantly in the form of asset-backed-securities (ABS).

Of $17 billion of total debt on December 31, 2019, the company raised about $13 billion through “vehicle debt,” which represents debt issued by a wholly-owned subsidiary of the company via securitization transactions. In these transactions, the subsidiary raises funds through bond-sale in the ABS market and uses these funds to buy cars. Hertz, the rental company, leases these cars from the subsidiary. The lease payments made by the rental company to the subsidiary are, in turn, used to pay back the ABS's investors.

The asset-backed-securities are collateralized, i.e., secured, by the cars bought by the subsidiary. Interestingly, the securities are divided into several levels of seniority. As an example, Hertz issued about $370 million in its Series 2015-2 Notes (see the press release) in 2015. It had four classes of securities: $265.3 million as the senior-most Class A security, $64.7 million as Class B, $20.0 million as Class C, and $21.2 million as the junior-most Class D security. These securities provide different levels of risks and rewards, making them attractive to a wide range of investors from hedge funds to insurance companies.

The net result of this complex transaction is that the company ends up raising funds from a diverse set of investors using several classes of securities. In good times, this is a great mechanism to raise funds at a relatively cheaper rate than traditional sources of funding, such as banks or other large investors. However, the more competitive price comes with some severe downside risks: if the issuer gets into trouble, its ability to renegotiate the terms of debt gets severely compromised under this structure.

The company ends up with too many lenders and too many classes of securities in an ABS transaction. These investors typically have different incentives; for example, some of them want to maximize their short-term profits, while others focus more on the long-term value. Similarly, owners of different classes of securities may disagree on the right course of action for the company's management. For example, the senior security holders might prefer to liquidate the business and get their cash right away, whereas the junior claim holders might prefer the opposite. After all, the junior claim holders stand to lose everything to the senior claim holders if the company liquidates at a low value, but there is always hope for the company’s resurrection if it stays in the business.

As a result of these differences in incentives and preferences, it becomes tough to come to an agreement with various parties in any renegotiation plan. Additionally, ABS creditors are dispersed all over the country, and perhaps all over the world, making any possibility of renegotiation even harder. Indeed, Hertz could not renegotiate its debt with all its creditors to stave off the bankruptcy. As per the court documents, the company was able to get temporary relief from some of its lenders through a forbearance agreement, but it could not reach an agreement with all of its ABS creditors. An out-of-court deal could not be reached in the end, and the company had to file for bankruptcy.

The inability to reach an out-of-court settlement is proving to be very costly for Hertz, and sadly for its employees. The used car market prices have already been under stress due to COVID-19. Prices fell by more than 10% in the month of April as per a used car price index. In the bankruptcy proceedings, the company will likely end up selling a large number of its vehicles under duress. Such action will depress the used car sale prices further. An orderly, gradual sale of its fleet, without the pressure of a bankruptcy court, would have fetched the firm more dollars, making all the stakeholders better off. Absent that, the company’s fleet of 700,000 cars is rapidly losing their value.

Not only that, the credit rating agencies ended up downgrading the ratings of the company’s asset-backed-securities and other bonds as the trouble started to intensify. With the downgraded rating, the company’s securities became ineligible for the Federal Reserve Bank’s support under asset-backed-financing scheme. In essence, Hertz’s bankruptcy is a self-inflicted wound on the company.

Hertz’s top management needed to work harder, despite the difficulties in renegotiating the debt with diverse bondholders, to avoid these costs. Unfortunately, the company had too many CEO changes in the past five years, making it hard for the top management team to nurture a deep relationship with their investors. Renegotiation is extremely difficult without a strong relationship with the company’s investor base.

What could have been done by the company’s top managers to avoid getting into such a situation in the first place? Excessive reliance on the securitization market gave the firm, and its investors, a false sense of security in good times. It continued to raise a lot of debt by tapping the ABS market. A good starting point would have been to build a higher level of equity capital, and lower its debt levels right after the company became public in 2006. But the company could never get rid of its LBO DNA. The deleveraging never happened. Another sensible approach would have been to keep a much higher level of cash balance than the company actually did.

Hertz’s demise serves as a great learning moment for financial analysts and CFOs. While the securitization market provides a cheaper source of funds, it makes debt renegotiation harder than traditional sources of funding, such as bank debt. This cost is especially onerous for large companies since the anticipation of their distress depresses the price of their assets. To be sure, the ABS market does provide an excellent way to diversify a company’s funding base. Securitization can be a great tool to raise funds at an attractive rate, but it makes sense to do so only if the firm is able to keep its default likelihood low.