How debtors and creditors steered Carvana away from bankruptcy

Ernie Garcia last December was preparing for a battle royal with creditors, whom he feared were planning to push Carvana, the online used car marketplace he built with his father, into bankruptcy.

A former high-flying tech start-up, Carvana’s market capitalisation had dropped from $50bn to $1bn when, amid soaring interest rates, the number of cars it sold in a year fell for the first time in its history and it burnt through nearly $4bn in cash.

Garcia expected the worst as bondholders who were owed nearly $6bn, including asset managers such as Apollo and Ares with a reputation for toughness, had agreed to band together in negotiations.

But this week, the showdown was averted. Carvana and the creditor group announced a consensual deal in which the money managers would agree to a 24 cent-on-the-dollar haircut on their previously unsecured debt. In exchange, Carvana would swap new bonds secured with the company’s assets as collateral.

Carvana will also raise at least $350mn in new equity, with the Garcia family putting in more than $100mn. In an accompanying press release, John Zito, a top Apollo executive who led the creditor group, even praised the compromise as a template for future dealmaking. Carvana’s share price jumped more than a quarter and is up 10 fold from its December lows.

The case of Carvana shows that some of the biggest debt managers in the world are betting that peace agreements can be a better approach than the bitter fights that still characterise many interactions between indebted companies and their creditors.

“Squeezing the last drop out of your contractual rights can help you prevail in any one contest,” said Vince Buccola, an associate professor at the Wharton School.

“But a reputation for sharp practice can prove costly over the long term, where the economics are not so obviously zero sum but instead turn on others’ wanting to do business with you.”

Apollo’s credit business already boasted a longstanding relationship with Carvana before the Arizona-based retailer’s fortunes turned upside down.

The investment firm had studied Carvana closely and believed that the fragmented US used car market needed an online player, a bet that paid off during the pandemic: Carvana sold more than 400,000 cars in 2021. It bought nearly a billion dollars of a $3bn junk bond that the company issued in spring 2022. Apollo had also been an active buyer of securitised auto loans Carvana had originated over the years.

Apollo is best known for its original leveraged buyout business, which also bought up distressed debt of companies through its private equity funds that it wished to eventually control. 

However, its separate credit segment, that is tied to its retirement annuities business, has become Apollo’s growth engine. Credit now accounts for more than $400bn of nearly $600bn of assets managed. With that capital base, Apollo had lent hundreds of millions or even billions in single transactions to such companies as Air France, Hertz, SoftBank, AT&T and Anheuser-Busch.

These large deals with blue-chip players required the firm to develop collegial relationships.

Still, Garcia remained wary of the Apollo-led group, which had hired a well-known bankruptcy lawyer, Tom Lauria of White & Case. Carvana was also spooked by an initial restructuring offer from Apollo in which the company would issue $1bn in shares, substantially diluting the Garcia family’s control. 

The bondholders, for their part, were worried that Carvana’s legal counsel at Kirkland & Ellis was cooking up an increasingly commonplace strategy of divide-and-conquer among individual bondholders. 

As tensions escalated, the company launched a modest-sized public bond exchange offer in March to reduce its debt by a few hundred million dollars.

The Apollo group rejected the offer, but then Carvana’s fortunes began to turn again. 

The company’s results improved in line with calmer capital markets and positive signals from the US economy. By the end of the second quarter, Carvana had cut $1bn of annual expenses, which was good enough for the company to flip into positive Ebitda.

“Many elements of our plan have played out how we had imagined them”, said Garcia. “We were always going to have to cover ground on building ‘scale’. And then cover ground on the ‘economics’ of the business. We’ve done that, even if it was not the most elegant of paths.”

In spring, Ken Moelis and William Derrough, two of Carvana’s investment bankers at Moelis & Co, visited Apollo’s Zito in his office at Apollo’s New York headquarters in an attempt to lower the temperature, according to people familiar with the meeting. 

At the same time, according to these people, Zito launched a charm offensive with Garcia, having dinner with him several times and explaining to the CEO that Apollo came in peace and that there was a fair deal to be struck benefiting all sides.

“We found reasonable people on the other side. It did not match the caricature in the media,” Garcia told the FT, referring to Apollo and the other bondholders.

Carvana was able to shave off more than a $1bn in bond principal as well as defer hundreds of millions in annual cash interest expense for two years. The creditor group, too, won important concessions. For example, its previously unsecured bonds are now ranked senior and secured against Carvana assets. 

Carvana will retain the ability to issue some more debt, but the covenants in the legal documentation have been tightened to restrict the company’s ability to act unilaterally. Many of the Bondholders had bought most of their bonds at distressed prices, so their 76 cents on the dollar exchange was still lucrative. 

One person close to Apollo said that the firm found it “frustrating” that its reputation for harsh tactics towards counterparties persists. A messy bankruptcy fight that Apollo’s aggressive private equity group waged this year at Serta Simmons had garnered outsized headlines even as the firm’s investment was less than $50mn

This person added that even that group had come to accept that a less contentious posture at times might prove more sensible.

Upheaval in the commercial banking sector since the financial crisis has meant private equity firms have become substitutes for banks, requiring those firms to be less opportunistic in exchange for an enormous financial opportunity, explained Steven Kaplan, a professor at the University of Chicago.

“In repeated relationships, there are better outcomes by not being overly confrontational.”