From the customer’s perspective, car rental is a straightforward business. The only uncertainty is whether the hire company will charge you for the scratch they discover when you hand back the vehicle. 

Hertz Global Holdings Inc.’s bankruptcy protection filing on Friday was a reminder that today even the simplest business models are underpinned by a lot more financial complexity than meets the eye. Rather than make the rental giant more robust, financial engineering seems to have made Hertz more brittle.  

The proximate cause of Hertz’s demise was of course the sudden collapse in bookings caused by coronavirus travel restrictions. The company’s monthly revenue  fell 73% year-on-year in April, a shortfall that even the most resilient companies would struggle to withstand for long.

But Hertz’s complicated financial plumbing contributed to it becoming one of the most high-profile companies to seek protection from creditors during the corona crisis. This byzantine organizational chart from the bankruptcy filing gives you just a taste of what lies underneath the company’s hood:

In the decade preceding its collapse, Hertz took on too much debt, participated in overpriced M&A and was accused of playing accounting games to pad its earnings. (For more, read this colorful account from Bloomberg’s David Welch.)

So when disaster struck and a request for a government bailout was rejected (rightly in my view considering top shareholder Carl Icahn is worth some $18 billion), Hertz was already standing far too close to the precipice. Regrettably Covid-19 will probably expose more of this type of corporate frailty, both in America and around the world.

Hertz’s debt binge began when it was acquired by private equity firms from Ford Motor Co. in 2005; the new owners quickly took out a $1 billion dividend. Piling on debt juiced the potential returns for the owners and helped pay the inflated $2.3 billion price tag for the Dollar and Thrifty brands in 2012, which Hertz struggled to integrate.

Hertz was only able to amass an eye-watering total of $19 billion in borrowings thanks to a massive program of asset-backed lending, which became its primary source of capital.(2)

Special-purpose financial entities purchase cars on Hertz’s behalf, and investors in the asset-backed securities make a return via the lease payments that Hertz is obliged to stump up. Put another way, Hertz leases cars long term from the financing subsidiary — typically for about 18 months in the U.S. — and then rents them out to customers for shorter periods.

In theory, this is a stable and low-cost way for a risky borrower such as Hertz to fund the large capital outlays needed to keep its fleet looking fresh. Hertz’s corporate credit has been rated junk for the past decade but many of the asset-backed securities it issued were triple-A rated, at least until recently. However, economic shutdowns stemming from efforts to curb the new coronavirus suddenly threw a lot of sand in Hertz’s gears: The resale value of its vehicles fleet fell sharply, requiring the company to inject more cash into the financing structure.

With only about $1 billion of cash on its books, Hertz was ill-placed to fund that collateral call, and the pandemic meant it wasn’t able to sell vehicles to generate cash because potential buyers were confined to their homes and auctions and dealerships were closed. (Hertz’s chief financial officer describes these acute pressures in this filing.) 

Asset-backed securities holders appear to have decided that allowing Hertz to fall into bankruptcy will prove no impediment to them getting most of their money back, at least for those holding the better-rated tranches of debt. The same can’t be said, however, for Hertz’s unsecured lenders, or its shareholders. Building a 39% stake since 2014 probably cost Icahn about $1.6 billion, based on a Bloomberg average share-cost estimate, but he now risks being wiped out.   

Hertz’s predicament was made more severe because in the U.S. it couldn’t hand back most of its surplus vehicles to the manufacturer, as is common practice in Europe. Instead it faced the task of selling them itself and bore the risk of any unexpected depreciation. The company is one of the 10 largest sellers of used vehicles in the U.S.

The preponderance of these so-called “risk vehicles” in its half-a-million strong U.S. car fleet has increased since 2014 because it was more profitable than paying a premium to the manufacturer to guarantee a fixed repurchase price. There’s no reward without risk, though, as Hertz’s bankruptcy filing made abundantly clear. 

Having lost money in three of the past four years, Hertz did seem to have turned a corner lately: It raised capital to pay down debt last year and was ranked No. 1 for customer satisfaction in J.D. Power’s North American car rental rankings. Not that customers have much choice. Consolidation has given just three groups — Hertz, Enterprise Holdings Inc. (owner of the National and Alamo brands) and Avis Budget Group Inc. — control of almost the entire U.S. market for airport car rentals in the U.S.

New competition from ride-hailing companies and a litany of management missteps meant Hertz never achieved the pricing power that Icahn and other recent investors probably assumed would come from all that merger activity. Because the industry’s fortunes are so closely tied to air and business travel, car rental demand is likely to remain weak for a while.  

Still, Hertz remains open for business and thanks to the more lenient Chapter 11 process it should get another chance to make a success of that oligopoly, albeit as a smaller company with different shareholders and a new capital structure. Next time you return a rental car, expect the attendant to check even more thoroughly for dents and scratches.  

(1) $14.7 billion of Hertz’s debt relates to vehicle financing

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Chris Bryant is a Bloomberg Opinion columnist covering industrial companies. He previously worked for the Financial Times.

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