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New idea – Casper Sleep

puppyeh

There have been a number of requests for more short ideas, and fortuitously a stunningly asymmetric opportunity has cropped up in this vein. This is a very simple idea, and most timely, so I will try to keep the write-up as brief as necessity allows and answer any questions in the Q&A.

Casper Sleep (Nasdaq: CSPR) – last price 6.68 – $280mm market cap, $10mm ADV

Thesis Summary: Casper Sleep, a cash-burning, dumpster fire of a direct-to-consumer bedding and mattress company, is in the process of being acquired by Durational Capital, a small/unknown PE firm, for $6.90 a share. CSPR equity currently trades at 6.68, meaning there is a 3.5% gross spread to a deal purportedly going to close in the very near term (late January/early February). Despite the market pricing in a ~95% chance of deal closure, I believe this deal has quite a large chance of either being recut much lower, or perhaps abandoned entirely. Firstly, the acquiring firm is opaque, unknown, and with almost no pedigree in deals of this nature; more importantly, they do not have the required capital to close, and are thus relying on equity commitments from LPs who may well baulk at taking on a highly distressed business at an irrationally high price. Secondly, the proxy statement makes clear that absent an immediate transaction, CSPR would be essentially bankrupt and in need of restructuring – indeed the other two ‘offers’ received for the business were hugely dilutive and/or basically out-of-court restructuring transactions. Such is the distress of CSPR today that even if the purported deal goes through, they are likely to need another large financing later in 2022. Thirdly, even if the deal does manage to go through in some form, since basically all CSPR’s direct D2C comps have declined 40-50% since this deal was announced, Durational has both the negotiating leverage, and a very reasonable argument, that the deal’s valuation needs to be recut, significantly.

The attraction of this trade is the huge asymmetry at play. If the deal goes through at terms, we lose a few percent and simply move on. But if the deal breaks in some fashion – either recut, or all the way – we could make a small fortune. The stock traded at $3.2 before the deal was announced, but this price did not reflect horrendous 3Q numbers, nor the atrocious 4Q implied guidance; ongoing cash burn; lack of other alternatives for the business; and the massive derating faced by these kinds of stocks in recent sessions. I believe the stock would fall >70% if the deal breaks in the next month. Even a recut of the deal to something more palatable (for the buyer) would suggest something like 40% downside In other words I think the set-up is about as ‘option-like’ as one could hope for in a setup like this.

As a special situation/event trade, I will focus most of my attention on the set-up and event path, and outsource most of the fundamental discussion.

Background

Casper is a direct-to-consumer bedding/mattress company based in NYC. Founded in 2014, it was originally an e-commerce only business, but has since expanded into other channels as the e-commerce channel has been beset by huge difficulties (too many competitors; large and increasing CAC; the nature of mattress purchases being once every 8 years, ie not lending itself to paying up to acquire essentially a one-time customer). This excellent report on VIC (in the public domain) gives you a flavor for the fundamental short case. Most of the analysis turned out to be spot on: the business has burned increasing amounts of cash; missed estimates consistently by a large margin in recent quarters; and, as recently as mid-September, was laying off basically half the C-suite.

The market was therefore SHOCKED in mid-November when Durational Capital, an unknown NY-based private equity fund, announced a deal to acquire CSPR for $6.9 a share – a 115% premium to the then-price, with no financing conditions. Since announcement, the stock has traded up, basically close enough to the deal price to imply a very high likelihood of deal closure in the near-term. This is where our story begins.

Who is Durational? And do they have the money to close?

There were a number of oddities about the deal from the jump. For one, Durational Capital is not a name that anyone I knew – and I know a fair few people in this demimonde – had heard of. A quick check of their website shows only three total investments since founding in 2017, of which only one was a completed takeout (the other two, Churchill Downs and Sanderson Farms, were simply public market purchases). Said completed purchase – the acquisition of Bojangles in 2019 – was in partnership with The Jordan Company – an actual PE shop with pedigree, a 40 year track record, and a huge amount of ample capital at its disposal.

By contrast, you may be struck by some of the details on the Durational Capital site (or lack of them). There is no disclosure of AUM. Moreover neither of the founders appears to have any direct PE experience or background at all. Bizarrely, the lead left founder, Matthew Bradshaw, was previously a long/short equity fund manager at Millennium, a pod shop best known for short-term tactical trading (hardly the province of a soon-to-be PE dealmaker). The other founder (and apparent lead on the CSPR investment), Eric Sobotka, also came from a long/short equity background at Eminence, and while he apparently had leveraged finance experience at Lehman and Lazard, it would similarly be a stretch to call him a PE type as well, prior to this venture. I am not attempting to denigrate their skills or background; it is simply a rather odd look for an acquirer and well beyond the norm. This led me to further digging, as I wanted to understand how much capital they were managing, and what they had been doing with it.

Luckily, as an SEC-registered vehicle, there is a decent amount of data available. You can see here, for example, that as of September last year, Durational had zero active positions. This struck me as somewhat strange, given they list the Bojangles investment as ‘live’ on their site and still have two members on the board (but perhaps that investment is housed in a separate vehicle or something and thus not reportable under the Durational Capital Management banner). In any case upon further digging and examination of the latest Durational ADV and brochures, it appears they are managing only ~$240mm in assets, and zero outside accounts (SMAs). In fact it appears the sum total of their assets may simply be an allocation from a single account:

This (relative) lack of experience and financial resources bears considering as we now think about the financing structure, and needs, of the CSPR deal. Per the Merger Proxy, the CSPR acquisition will require a total financing commitment of $415mm, comprising $375mm of equity and up to $100mm of debt financing. The key point, I believe, is that Durational is NOT providing the equity check: they have rather furnished an ‘Equity Commitment Letter’, meaning they essentially guarantee they will be able to source the equity check upon closing (presumably from their LPs or network, etc). From the Proxy:

I apologize for this strong dose of ‘legalese’, but the essential point is, CSPR’s board is trusting that Durational’s Equity Commitment Letter is money good (it is not included in the Proxy, of course, so we as investors have no way of assessing its quality or the ‘terms and conditions’ attached to it). The $100mm debt financing from is probably good (even though there are ‘outs’ there too for KKR, if the Equity Commitment doesn’t close). But the rub of the deal is simply this: will whoever Durational got to sign the Equity Commitment Letter stick to their commitment and actually provide $372mm of capital to close this deal? Because Durational (the GP) certainly can’t cut that kind of check, looking at their AUM and apparently very limited other resources.

In sum, before even looking at the business and its current state, I was scratcing my head wondering what exactly was going on.

The Proxy tells a tale of a business teetering on the brink of insolvency

As in any merger document, there is a fascinating section of the proxy that describes the ‘play-by-play’ negotiations and events that led up to the current deal (see pp 26-36 of the Proxy, ‘Background of the Merger’). Without taking you through every twist and turn, suffice to say that the main takeaway from reading these 10 pages is that CSPR was, and is, in serious financial distress. Consider some of the following points (again, all drawn from the Proxy):

Reading all the detail, it appears striking to me the contrast between the bids in this auction: Durational is willing to not only offer zero dilution to the existing equity, but offer an insane premium on top as well, whilst other (presumably sophisticated) bidders were only willing to offer DIP-like financing or highly-dilutive AND top of the capital structure toxic converts. It is almost as if Durational is bidding on a different company than the other bidders!

At the same time, I get the impression Durational was ‘played’ by Jefferies, in a sense, being led to believe there was competitive tension in the process when in reality there was daylight between all these structures and the Durational bid. I wonder how Durational feels today, reading through this Proxy – they were the only real bidder all along and may well demand a price cut on that basis, at the very least…

More importantly, however, the document makes crystal clear the financial jeopardy CSPR finds itself in today. Management projections as of the original proxy date – early December – suggest the business would burn a huge amount of cash ($30mm) in the pre-merger period:

We also know, for a fact, that covenant waivers were only granted by the lenders because of the pendency of this transaction – meaning without this deal, CSPR would most certainly be a going concern risk:

Finally, and perhaps most crucially for the event path we are most interested in, Management’s near-term cash flow projections suggest CSPR will run out of cash, entirely, in late January:

Note also that these numbers have likely deteriorated given the weak operating environment, and increasingly deleterious credit card data for CSPR in recent months. But even so, the fact that CSPR – even before the deal closes – may essentially be tapped out, gives Durational a HUGE amount of leverage should they even threaten to try to pull out of, or express a wish to recut, this deal. What exactly are CSPR’s other options at this point?

Durational’s choices: close, recut, or break?

At this point you may be thinking, ‘it certainly seems like CSPR is in a rough state, but a Merger Agreement is binding, and given the tight Material Adverse Change clause how exactly could Durational break the deal if they wanted to?’ Well, putting aside the reality that in a situation like this, often the letter of the law is less relevant than the leverage of the parties involved, and merely the threat of walking away would be enough to force a recut of the price, in this specific case, I do think there are reasonable grounds to break the deal (or at least demand a renegotiation) on its merits. Here is why.

  1. Solvency clause in the Reps & warranties: as is customary in any merger deal, as part of the closing process, CSPR will have to guarantee they are solvent. See below (clause 4.13 of the merger agreement, p. A-41):

Given the parlous state of CSPR’s finance at year-end, let alone the end of January; the lack of obvious financing alternatives; and the ongoing violation of CSPR’s covenants, I think Durational (or their LPs) could make a very strong argument that CSPR fails the solvency test and thus refuses to close the transaction on current terms.

2. Inability to close Debt/Equity financings: as I have discussed, the dilemma facing Durational’s LPs – the ones on the hook for the equity commitment, at least – is that even a cursory look at the deal in light of the company’s fundamentals (and what is going on in the market for similar companies) will show they overpaid by >100%. Thus they will be forced to make a choice, do we honor our commitment to Durational (f they demand we do) and take an immediate 50-70% haircut on our investment (and likely need to put up $50-100mm more capital in 2022); or do we baulk and wait to see if Durational tries to sue us to complete?

This brings up the obvious next question – would Durational sue to compel completion? At this point Durational GPs – Messrs Saunders and Sobotka – would have to weigh the perceived benefits of closing (financial or reputational), against the immediate (and gargantuan) financial and reputational losses of completing a deeply-underwater deal. While of course anything is of course possible, given Durational is a very young firm, with nary a deal under its belt, minimal resources, and not much of a reputation as it stands, I would be SHOCKED if they attempted to compel LPs who wanted to back off at closing to honor their commitments. It would essentially burn their reputation, for good, and to what benefit? They wouldn’t even make much in terms of fees on the deal since 1) the deal would be immediately massively underwater (and may file anyhow later on); and 2) the closing fees, per Durational’s fee template, are not significant, either in absolute or relative terms:

In this case, EV at closing would be something like $350-400mm (depending on cash burn, etc) meaning 1% would be say $3-4mm, but only 1/3 of that – so maybe $1-1.5mm – would be available at close as the completion fee to the GP. Would Durational blow its reputation and future earnings potential for $1mm now and putting its LPs 70% in the hole on Day 1? Of course they theoretically could…but it seems a dastardly move to actually go through with.

The case for a big recut (the most likely outcome?)

It seems to me, then, the most likely outcome of all is perhaps a significant recut of the transaction price. CSPR desperately needs the deal to close (it needs cash!); Durational, for all its effort and notwithstanding all of the above, still probably wants to close a deal of some kind. The issue is simply the business has deteriorated, the original price was wrong (thanks, Jefferies!) and the market environment has changed. The proxy demonstrates a willingness on both sides to renegotiate; why wouldn’t both sides simply agree to cut the deal lower again?

CSPR is growing revenues but strongly negative EBITDA and burning cash, so it is hard to benchmark valuation against anything ‘real’. One way to think about what is reasonable, though, is what a control premium would look like, today, against where the stock would have possibly been had the deal not been announced. In this vein, if we consider that CSPR stock was $3.2 when the deal was announced; that they then cut Q3 and 4Q numbers, aggressively; that most all other loss-making D2C consumer brands like WRBY, BIRD, SDC, PRPL, etc, are -40-50% or so since the CSPR deal was announced; and that CSPR is the biggest going-concern risk of the lot, I think its reasonable to consider a $2 stock price as the standalone extant price. Frankly I think CSPR may well have already filed, or be in the process of filing without this deal, but in any case – even if we applied a similar premium that Durational was willing to pay (115%) to that new, lower, level, we would still only get a $4.2 stock…or ~38% downside from current. In other words, I believe in a deal recut scenario this trade would payoff, in the base case, something like 10-to-1 (risk 3.5%, make 35-40%). And clearly I am not precluding the possibility that Durational simply refuses to close and tries to walk, saying something like ‘sue us then’ to a company that, in a couple of months, would likely land in bankruptcy court in any case. And if Durational truly walks away, the equity probably falls 75%+ given the obvious deep distress.

Obviously, this is a ‘negative carry’ trade in that if the status quo prevails, we will lose a few percent. But given the huge asymmetry and event path as I see it, this seems a hgihly attractive proposition and thus I am entering it as short position in the book.

Disclosure: short CSPR

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