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Lampert’s Hedge Fund Buys Junk-Rated Paper From Lampert’s Sears

Date: Thursday, April 15, 2010
Author: Bloomberg

Sears Holdings Corp. is bypassing barriers to junk-rated companies in the $1.1 trillion commercial-paper market by selling the debt to its largest stockholders, including Chairman Edward Lampert.

Lampert and his hedge fund, ESL Investments Inc., bought $150 million of 30-day commercial paper from a Sears subsidiary in March, the Hoffman Estates, Illinois-based retailer disclosed in its annual proxy filed April 6. Fairholme Capital Management LLC, the second-largest Sears shareholder, disclosed in a separate regulatory filing that its main mutual fund held $150 million of the retailer’s commercial paper as of Nov. 30.

The Sears debt pays 1.9 percent a year in interest, about 10 times the yield of commercial paper issued by top investment- grade companies such as General Electric Capital Corp. Sears gets an alternative to borrowing under its bank credit line at a minimum of 5.75 percent, said Steven Shachat, managing director of fixed income at Alpine Mutual Funds in Purchase, New York.

“You would have to say to yourself, ‘That is pretty good for the corporation’,” Shachat said. “There is no doubt that 1.9 percent, relative to what you could get on the investment- grade side, is very attractive. But the bottom line is, it isn’t even close to investment grade.”

Kimberly Freely, a Sears spokeswoman, declined to comment, as did Steve Lipin, an outside spokesman for Lampert’s Greenwich, Connecticut, hedge fund. Bruce Berkowitz, the managing member at Miami-based Fairholme, didn’t return telephone calls seeking comment.

Debt-Equity Swap

Lampert, 47, gained control of Kmart Corp. in a debt-equity swap in 2003 and merged the retailer with Sears, Roebuck & Co. to form the nation’s largest department-store chain. He and ESL own 65.3 million Sears shares, the equivalent of a 57 percent stake, while Fairholme held 15 million shares as of Dec. 31.

The Sears audit committee reviewed and pre-approved the sale of commercial paper to Lampert during the fiscal year ended Jan. 30, according to the proxy filed with the U.S. Securities and Exchange Commission. The transactions occurred March 15, when finance subsidiary Sears Roebuck Acceptance Corp. sold $50 million of 30-day unsecured commercial paper to Lampert and $100 million to ESL, according to the proxy.

Commercial paper, the term for corporate debt that generally matures within 270 days, gives companies a cheaper alternative to bank loans for short-term financing. The majority of commercial paper issued in the U.S. is sold to money-market funds, which are only allowed to invest in debt that carries the top two short-term credit ratings.

‘An Oxymoron’

Companies such as Sears Roebuck Acceptance, whose debt rating from Standard & Poor’s is four notches below the minimum level for money-market holdings, are often shut out of the commercial-paper market. According to U.S. Federal Reserve figures released April 8, there was about $883 billion of top- rated commercial paper outstanding and $39 billion of debt with the second-highest grade. The remaining $168 billion of commercial paper outstanding consists of securities “ineligible” for purchase by money-market funds, according to the Fed.

“Junk commercial paper is an oxymoron,” said Peter Crane, president of Crane Data LLC, a Westborough, Massachusetts, money-market research firm. In response to the September 2008 collapse of the $62.5 billion Reserve Primary Fund, the SEC tightened restrictions on money-market investments in January, requiring funds to hold at least 97 percent of their assets in the highest-rated paper.

Decreased Borrowing

Sears’s amount of outstanding commercial paper rose to $206 million as of Jan. 30 from $7 million a year earlier, according to the annual report. The company reduced borrowings under its bank line by $316 million.

“While we decreased our total amount of short-term borrowings in fiscal 2009, we also altered the mix of our funding to include more borrowings in the commercial-paper market,” Sears said in its annual report. “The increased level of funding from commercial paper reduced our total borrowing costs,” with cash interest paid declining to $185 million from $207 million the prior year.

Under its $2.4 billion bank credit line, Sears can borrow money at a rate equal to the London Interbank Offered Rate, or Libor, plus 4 percentage points, according to the company’s annual report. The minimum Libor rate used to make the calculation is 1.75 percent. One-month Libor as of yesterday was about 0.25 percent, according to data compiled by Bloomberg.

Investment Alternative

Investors such as hedge funds and insurance companies are searching for alternatives to the low yields on investment-grade commercial paper in which to park their cash. GE Capital’s 30- day commercial paper yields 19 basis points, according to data compiled by Bloomberg. A basis point is one-hundredth of a percent.

“Most of the lower-rated commercial paper is bought either by insurance companies or hedge funds who are trying to manage liquidity and have the ability to buy something at a BBB or lower level,” said Alex Roever, a short-term debt strategist at JPMorgan Chase & Co. “If one of these institutional investors is willing to own long-term debt or equity, a lot of the time they are comfortable holding the commercial paper.”

Lampert’s annual letter to Sears shareholders, published in February, criticized credit-rating companies for using “simplistic analyses” that result in Sears having a lower rating than peers and thus paying higher interest costs. As an example, Lampert cited the rating firms’ assumption that capital investments in stores are more favorable for bondholders than stock repurchases. Sears has a higher stock-market capitalization and less overall debt than some competitors with higher credit grades, he said.

“We do some things differently than others, and we have certain beliefs that differ from theirs,” Lampert wrote.