Carvana

Carvana's stock is once again on the rise, harking back to its high-flying days during the pandemic. However, the bonds of this used-car dealership hint at a looming risk of default.

The fluctuations in the market may not be a reliable indicator of Carvana's future prospects. Rather, its past and how its largest shareholder managed to thrive amidst struggles, while leaving some investors discontented, may provide a better roadmap.

Carvana is overseen by Ernie Garcia II, father of Carvana CEO, Ernie Garcia III. The elder Garcia owns DriveTime Automotive Group, from which Carvana started to spin off in 2015.

Over twenty years ago, the company that would eventually become DriveTime had a successful IPO, saw rapid growth fueled by borrowing, but then hit a rough patch. Garcia II took the company private, leading it to prosper and amass a significant fortune for him. This left DriveTime's investors disgruntled, claiming they were dealt an unfair hand.

Investors in Carvana's debt are observing this carefully. They took an extraordinary measure of banding together against the Garcia family, apprehensive of the company's efforts to strip Carvana of its assets. They even hired private detectives to estimate the Garcia family's net worth, according to insiders. A proposed plan for debt restructuring by the company fell flat.

The companies are as intertwined as the Garcia family members themselves. Carvana rents properties and procures cars from its former parent company. Other firms within the Garcia family's network service Carvana's loans and offer insurance products to its customers. Transactions between these companies generate hundreds of millions in revenue for the family business.

Currently, Carvana is attempting to make a comeback, with stock market investors hoping for its success. From a starting point near $4 earlier this year, Carvana's shares have skyrocketed to about $40. However, this is still nearly 90% lower than its highest point in 2021.

Bondholders remain doubtful. A considerable portion of Carvana's close to $6 billion bonds are trading below 70 cents on the dollar. There are multiple lawsuits against Carvana by investors alleging that the Garcias have been operating the company primarily for their own gain.

DriveTime found itself in a similar situation more than two decades ago when its shares were trading far below the IPO price.

For Garcia II, the used-car market was a second venture. In the early 90s, he pled guilty to felony bank fraud in relation to fake deals with Charles Keating Jr., linked to the Lincoln Savings & Loan scandal. After providing "extraordinary assistance" in the investigation, he received a $50 fine and three years probation and filed for bankruptcy.

Emerging from the scandal, Garcia II purchased a bankrupt rental car business, Ugly Duckling, and transformed it into a chain of used-car dealerships for buyers with poor credit. They charged high-interest rates and were quick to repossess cars from defaulting borrowers.

The business shared many similarities with Carvana. Both companies sold loans to investors, boosting their earnings. Like Carvana, Ugly Duckling issued equity and debt to grow, expanding from seven to 76 dealerships within four years.

By 2001, amidst a broader economic downturn, Ugly Duckling began losing money.

Some shareholders claimed that Garcia was devaluing Ugly Duckling's shares. The board initiated buyback programs and swapped equity for debt, augmenting Garcia's ownership. Some of Ugly Duckling's assets were also inexpensively transferred to Verde Investments, Garcia's private firm.

In one case, Ugly Duckling sold 17 properties to an unrelated entity for $27.4 million and leased them back. The next year, Verde purchased these properties from the entity for $24.7 million.

In 2002, Garcia II managed to privatize the company on his third attempt, providing shareholders with less than half of the original IPO price from five years prior. He settled with Ugly Duckling investors who claimed inappropriate insider trading. The Ugly Duckling brand was replaced with DriveTime, and by 2005, the company reported a profit of $83 million.

Ernie III became involved in the family business as a teen intern before attending Stanford University, where he met several people who would later become co-founders and executives at Carvana. His vision for Carvana was straightforward: digitalize the disjointed used-car market and use scale to reduce costs.

Carvana was initially a part of DriveTime. DriveTime's special technique involved selling cars to high-risk borrowers and aggressively reclaiming the vehicles if payments were delayed. According to the Consumer Finance Protection Bureau, around 45% of the company's loans were overdue at any given time in 2014.

That year, DriveTime paid $8 million to settle claims of harassing borrowers at their workplaces, among other allegations. The company neither admitted nor denied any wrongdoing.

Carvana targeted a higher-end market and built a customer-centric brand with humorous ads and huge glass "vending machines" that dispensed cars to buyers and doubled as oversized ads. The company also communicated to potential investors that its relationship with DriveTime gave it an "unfair advantage," according to those in the know. When unable to raise funds from Silicon Valley, Carvana turned to DriveTime and the senior Garcia.

In the summer of 2016, Carvana announced it had raised $160 million in funding led by an undisclosed institutional investor. A later disclosure revealed that Garcia II had contributed $100 million to this round.

When Carvana went public in 2017, the elder Garcia retained control of the company's equity, with the younger Garcia controlling another 28%. The company's online sales model thrived during the pandemic, causing Carvana's share price to multiply over four times, with the elder Garcia selling $3.6 billion worth of stock.

However, shareholders started filing lawsuits alleging that the Garcias were enjoying undue benefits from the business. In an ongoing case, shareholders criticized the board for allowing Garcia III to conduct a private stock sale early in the COVID pandemic, where he and his father collectively purchased $50 million worth of stock at a discount of roughly 10% below the market price. The two had coordinated their efforts, as per court documents.

The company's filings caution investors that the Garcias' interests might not align with those of the public shareholders. The filings also alerted that the Garcias might engage in an acquisition that could significantly increase Carvana's debt.

This is precisely what occurred last year when Carvana purchased used-car auction company Adesa. Lenders resisted the $3 billion the company sought to borrow to finance the purchase. Carvana then approached Apollo Global Management, a shrewd Wall Street lender that purchased hundreds of millions of high-yield bonds, assuming they were securing advantageous terms.

However, Carvana's business plummeted, and by the end of the year, the shares had dropped by 97%. The company engaged restructuring consultants renowned for their aggressive tactics to raise capital while removing collateral from lenders. Apollo's bonds suddenly appeared much more precarious.

Creditors detected the influence of Garcia II, whose significant ownership stake gives him the most to safeguard from dilution through a share sale or debt-for-equity swap.

Carvana did suggest a debt swap that would have imposed losses on lenders. This proposal fell through. Simultaneously, the company segregated the Adesa assets into a new subsidiary, stating that these assets no longer guaranteed the unsecured bonds initially used to purchase them.