Many Retail LBO's or Hedge Fund Buyouts May End In Bankrupcy

Implications: The eventual consequence for many retailers who are bought  through LBO’s or acquired by hedge funds may be bankruptcy or liquidation.  Here's why.

Analysis: Most retailers will survive this recession, but some will fail.  The question for investors is which companies.  Clearly, those firms that were in decline before the current slowdown started were obvious candidates.  For instance, Sharper Image, Bombay Company, Harvey Electronics, and Levitz were already in bankruptcy before the end of 2007.   

Now it’s evident that other firms like Linens & Things, Wickes, Lillian Vernon, Fortunoff, and Friedman Jewelers which were suffering from a combination of out dated strategy, inept management, and weak balance sheets should have been on most investor’s bankruptcy lists.  However, some investors were ‘gambling’ fourth quarter 2007 sales would sufficient to carry these business on for another year.  

While all different, many of the most recent bankruptcies have at least one thing in common, high debt.  It’s this catalyst as much as poor strategy or leadership that has weakened these companies and led to their failure.  For instance, Linens & Things, Wicks, Lillian Vernon, and Friedman Jewelers were all highly leveraged asset acquisitions by private investment companies and hedge funds    

Almost by definition, this type of acquisition requires the target retailer have high cash flow or at the least, the capability of generating a lot of cash.  However, that’s often the fatal flaw the highly leveraged buyout of a retailer.  That’s because most retail businesses are ‘cash hogs’.  Retailers have to support high fixed costs during most of the year.  They can’t just open the door during the highly profitable, cash positive, fourth quarter, but have to fund occupancy, inventory, and employee costs during the proceeding three quarters where cash flow is usually negative.  This also means most retailers require relatively high levels of short-term debt to fund working capital requirements.  

Many LBO specialists and hedge fund investors often see things differently.  First, it’s common for them to target inventory investment, staffing hours, and capital expenditure as opportunities to improve cash flow.  Form their point of view returns should be higher, so cutting product, service, and innovation to generate cash makes sense.  

Secondly, they sell off operating assets to maximize share holder value.  Of course retailers frequently lease back these assets which increase the firm’s short-term working capital requirements. 

Third, to generate returns, increased cash flow from assets sales and reduced operating expenses is used to pay interest and fees to debt a holder which reduces the firm’s reserves in case of an economic slowdown.  It also raises the risk to working capital suppliers and unsecured suppliers.   

The underlying assumption behind these buyout schemes is that sales and customer traffic won’t be affected by the changes, at last not before investors can make a profit.  But that assumption is usually wrong.   Disappointingly, top-line sales and profitability frequently decrease because as much as the business was uncompetitive before, it’s even more so afterwards. 

Granted many of these companies need to change their cost structure and reallocate investment to either their core business or new businesses for that matter.  But that isn’t what happens.  Most of the additional cash flows out of the business to service debt.   Eventually operating margins decline until banks and vendors cut off funding; forcing the company into bankruptcy.   

Under such circumstances, firms use to file for Chapter 11 to protect them from creditors.  This was especially advantages when owners were also the company’s largest secured debt holders.  However, after the passage of the Bankruptcy Reform Act of 2005, companies have less time for reorganization and unsecured creditors have more leverage.   

One such example is Friedman Jewelers which filled for bankruptcy for the second time in January 2008. Initially, several vendors petitioned to put the firm into Chapter 7 fearing hedge fund owners would file for Chapter 11 protection to recover their initial investment in the company, leaving suppliers with millions of dollars of worthless debt.  Later the court granted the company’s subsequent petition for a Chapter 11.  However, the court reversed its decision after the unsecured creditor’s committee objected to unreasonable low offers by both current owners and one outside bidder.  The firm is now in Chapter 7 liquidation within 90 days of the initial court filing.  

Fortunoff was sold to NRDC Equity Partners, owners of Lord and Taylor.  However, Wickes and Lillian Vernon’s bankruptcies are different.  It is unclear how the new bankruptcy laws will affect their reorganization process.  What’s clear is that much of the advantage owner-debt holders had under the old bankruptcy act to reorganize highly leveraged businesses in their favor have declined under the new act.  That may be why Linen & Things recently decided to postpone filling bankruptcy and returned to the negotiating table.  

Appearances may be deceiving, but it seems the combination of high leverage and hedge fund management isn’t always a good solution for troubled retailers.  It also looks as if hedge fund management tactics alone aren’t any better in turning a retail business around either. Sears Holding is probably the best example where hedge fund management strategies have been unsuccessful. Many analysts believe Sears the retailer is a “dead company operating” because of the deep cuts in staff, reduction in assortments, and lack of adequate new capital investment. 

Whether majority owner, hedge fund manager, and corporate Chairman Ed Lampert can recoup his investment in Sears and Kmart by selling off the company’s assets is heated debate in the investment industry. Most recently, Bank of America refused to renew Sears Holding’s one billion dollar working capital line under existing terms.  While the company says the change won’t affect liquidity [now], what seems certain is the Sears’ liquidation is imminent  

Another example is Zale Corporation where three hedge funds, including Breeden Capital Partners, own about 28% of the company.  Zale recently sold off its Bailey, Banks, and Biddle Division.  Now it’s closing about 100 stores, reducing inventory by $100 million, and cutting operating expenses by about $50 million, all while buying back $300 million in stock.  

Many industry professional’s doubt that current management can turn the company around.  If true, that leaves further asset sales or a corporate merger as the hedge funds most likely exit plan.  In spite of the fact that speculators are bullish on the stock now, it’s problematic whether majority hedge fund investors will recoup their investment.  

Whether either Sears or Zale will survive remains to be seen.  Poor management may have reduced their value to no more than the sum of their parts.  That seems to be the eventual consequence of many retailers who are unfortunate enough to be bought by through LBO’s or acquired by hedge funds, at least that’s true for the ones discussed here.