transcript: alternatives for a distressed company in apparel and retail
TRANSCRIPT
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TRANSCRIPT:
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Alternatives for a Distressed Company in Apparel and Retail May 9, 2013
CIT Trade Finance, Los Angeles, CA
Moderator Alexander B. Kasdan, Managing Director, DelMorgan & Co.; Founding Partner, Convergence Capital Partners, LLC Panel David S. Kupetz, Partner, SulmeyerKupetz George P. Blanco, Partner, Avant Advisory Group Steve J. Cupingood, CPA, Partner, SingerLewak Mitchell Cohen, EVP, CIT Trade Finance Event Organizer Anna Spektor, Founder and President, Expert Presence Kasdan: The subject of our conversation today is the life cycle of businesses in apparel and retail and restructuring alternatives for troubled companies. Mitch, as the dominant player in the industry, can you give us your observations of the marketplace. Cohen: CIT lends to companies involved in the chain of retail distribution and helps companies evaluate and minimize their business risks. We help companies with factoring, which includes the collection of money. In general today, the market is growing slowly, and that’s where CIT looks for opportunities to help clients operate more efficiently. When you talk about a healthy business today, it usually includes the following fundamentals: a diversified customer base and an excellent management team. The economy growth at 2% today is nominal, and the only way to grow a business is to make it run more efficiently and beat the competition by gaining market share. One of the hot topics today is the imposition of higher tariffs on denim in Europe up to three times historical levels. Denim manufacturers have to get creative to get around this: manufacturing in Mexico is one option. At the end of the day, this is just another hurdle that’s going to impact the industry and shift more manufacturing off shore. Kasdan: The industry has become very fragmented. From the investment banking perspective, the overall 2013 transaction volume and deal multiples are up compared to 2011 and 2012, yet companies have to come up with creative ways to
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diversify and maintain margins. There is a greater valuation disconnect between branded and non-‐branded apparel, and many retailers are struggling in this economy. David, from your perspective as a restructuring lawyer, what are some of the most common mistakes that retailers make? Kupetz: Maybe the easiest way to address that question is to give a quick case study that George Blanco and I worked on. No Fear Retail Stores was a company that licensed apparel products but got into retail. The company made a lot of typical errors. Management was very resistant to any outside help and refused to hire restructuring advisors. The focus was on what in hindsight certainly appear to be unrealistic financing opportunities -‐ the company attempted to go public through a reverse triangular merger with a small company listed on the Toronto exchange; the CFO was more of a controller; management paid little attention to customer base and marketing strategy. The situation ended up as a Chapter 11 expedited Section 363 sale. By the time No Fear hired a CRO (Chief Restructuring Officer), it was too late to turn the business around. It is very common that the owners’ resistance to hire outside professional advisors leads to the total deterioration of the business. No Fear failed to address cash hemorrhaging, while management needed to refocus its marketing strategy, the focus was misdirected to doing a complicated financing transaction. The owners lost track of running the business and its core strengths. The focus was on non-‐core retail operations. Overexpansion was another factor, with over 50 stores opened in a relatively short time, and with a number of them not profitable. Not focusing on core strengths is often a big error. Another factor was back office problems, which, CIT, for example could have helped solve. No Fear filed Chapter 11 too late. While it was able to secure DIP financing, the company’s internal projections proved to be off the mark, and the financing did not provide the runway the management projected. All internal projections and financials were prepared without the input of a CRO. We, as debtor’s counsel advised and creditors committee insisted the company hire restructuring professionals. Management thought the company had plenty of runway, which was not the case. Once hired, George quickly discovered the company required an expedited sale process. No Fear was a closely held company started by twin brothers – high energy, motocross, Nascar racers, who had a lot of great ideas over the years. Historically, the business was relatively well managed and probably could have reorganized had the professionals been brought in in time. Ultimately, we ran a successful sale process, with a Section 363 auction lasting until four in the morning, which ended as two separate, contemporaneous sales for IP rights to the company’s existing international venture partner who was competing in the bidding with private equity firms and the retail assets to an operator who would operate the business as a going concern under a different name and who outbid the liquidators.
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Ultimately, the equity holders and principals could have gotten better returns had outside help been brought in in time. Sooner rather than later is always better to maximize value. Kasdan: This is a very similar fact pattern to another transaction David and I worked on together, eStyle, Inc. or BabyStyle, where the company was in Chapter 11, was literally a “melting ice cube” heading for liquidation, and we had to run an accelerated sale process in under three months and ultimately sold the business to a strategic buyer, RightStart, owned by a private equity firm, Hancock Park Associates. George, from an enterprise value enhancement perspective, when is a good time to bring in a restructuring professional to return the company to profitability? Blanco: Obviously, sooner rather than later. Often, it’s a 60-‐90 days runway; a year is best. Even sophisticated buyers of services don’t think about advance notice. In the case of No Fear, the entrepreneur brothers built the company up by “guerilla” marketing and did not believe they could fail until it was too late. The challenge in being a CRO is getting the entrepreneurs and management focused. We also frequently rebuild value through an investment banker who can bring in outside capital. Cohen: One thing that always happens from the lender’s perspective is the management’s lack of focus on their inventory, which cannot be sold through normal channels. This has a direct impact on gross profit margins. Kasdan: David, how do you get distressed deals done in what has become a very competitive market, with a lot of money chasing relatively few opportunities? Kupetz: An acquirer can buy assets or secured debt to gain control. There are many different transaction structures for in or out-‐of-‐court restructuring. One is a Section 363 sale in chapter 11. There is a conventional Chapter 11 restructuring. For example represented American Home, a furniture retailer, which expanded beyond its core business, with many expensive locations. Through a prepackaged Chapter 11 plan, American Home liquidated out non-‐profitable stores to pay off a secured lender, reorganized around core New Mexico locations and restructured its unsecured debt. Today, however, you do not see too many conventional restructurings. Another option is an assignment for the benefit of creditors or an ABC, which in California is a non-‐judicial alternative to bankruptcy, with assets transferred to an assignee that acts as a trustee, with the responsibility to maximize the value of the assets under the circumstances and distribute the net proceeds to creditors. ABCs can be very effective but do not work in all situations. Generally, an ABC does not work for multi-‐location retailers that have many landlord disputes because the
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debtor does not have the benefit of the Bankruptcy Code Section 365, which allows the debtor to assign or reject real estate leases. ABCs can work well in the apparel and fashion industry, in appropriate circumstances, where a seamless transaction can be structured with lender consent, avoiding the uncertainty and minimizing the expenses of a Chapter 11 filing. Acquisition of assets of Fortune Fashion Industries by Jerry Leigh of California is a good example of a successful ABC transaction. Kasdan: In running a sale process in distressed cases, the timeline is very accelerated, where the buyers may not be able to do sufficient due diligence and have to make quick decisions based on available information, within the constraints of the legal system. David, can you comment on the recent legal decisions affecting the distressed marketplace. Kupetz: Last year, in the RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 132 S. Ct. 2065 (2012), the Supreme Court ruled that a secured creditor cannot be stripped of its right to bid under a Chapter 11 plan providing for a sale. The decision made clear that the same protections that exist for lenders in a Section 363 sale with regard to the right to credit bid also exist in the context of a Chapter 11 plan providing for a sale. There is continuing uncertainly in the context of a bankruptcy by a licensor, whether the trademark licensee has the right to retain the license. The 1984 Lubrizol (4th Cir. 1985) case held that a licensor was allowed to reject IP licenses in bankruptcy and strip out the rights of licensees, which was a pretty harsh outcome. Congress amended the Bankruptcy Code in 1988 to add Section 365(n) to preclude this outcome with respect to “intellectual property” licenses, but did not include trademarks within the definition of intellectual property. Moreover, the Sunbeam (7th Cir. 2012) case increased uncertainty regarding the state of the law in this area by holding that, separate and apart from Section 365(n), trademark licensees are entitled to protection under non-‐bankruptcy law that prevents bankrupt licensors from stripping out their rights and that Lubrizol was decided incorrectly. Another thing that is significant in the context of retail Chapter 11 cases is that there is a cap of 210 days on time now to decide whether to assume, assign, or reject leases. This has changed the dynamic of retail restructuring cases, as the debtor lessee no longer has the benefit of potentially unlimited time to make decisions with regard to leases. Kasdan: Next question is for Mitch and George. How is the intellectual property (IP) treated in restructuring? Do lenders perceive IP as a separate asset class, especially in the apparel context? Blanco: The question is always how to monetize IP. The value is in the eye of the beholder, but there is a substantial number of buyers of IP and a market, in the US, Europe and Asia. The issue is having something that someone else wants to buy and
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monetize, such as a national well-‐recognized brand. Look at the case of Quicksilver. Lenders will not lend against IP, although they say they will. Cohen: The challenge with IP is that from a valuation point of view, it is certainly in a separate class. The trick is to understand the value the day you make the loan. The value of IP is really cash flow driven. We have had some very successful brand liquidations. The common denominator was the owners’ management styles, as they tried to protect the brand. The actual business may not be profitable; however, the brand still has a lot of value in the marketplace. You have to protect the name and have control of the brand. You can still receive market value for the brand, even if the actual business is doing poorly. The company may not be making any money because its marketing expenses are way out of line, but the brand still has tremendous value and recognition. Blanco: Two quick examples of this: No Fear developed the whole portfolio of brands and marks. In another non-‐apparel case we worked on, over $300mm was spent on developing the IP and the last $20mm hedge fund investor, contrary to its expectations, got out $95mm at liquidation. Frequently, in these situations, you see a damaged company and don’t recognize that the value lies in non-‐tangible assets. Kasdan: How do you find value in distressed situations? The investor perception is that there are great opportunities to generate returns. How do you find the gems? Blanco: For me, there are two kinds. One, you help somebody acquire a pretty damaged, downsized company in Article 9, basically for the value of the equipment, employees and customer lists. The question is can you rebuild value. The other scenario is whether there is enough critical mass to strip out, so that you can take three-‐to-‐six months to rebuild backlog profitability. The more critical mass or assets there are, the easier it may be to rebuilt value. Otherwise, you may be buying “a melting ice cube,” with no possibility to extract value. Kasdan: Steve, what are the tax ramifications of doing distressed deals? Cupingood: Generally to the extent the debt is satisfied for less than its face value, there is going to be income. The question is whether the income is taxable. Generally, there are a couple of exceptions dealing with insolvency and bankruptcy. In these instances, if the company is in bankruptcy, the income is not taxable. If the discharge of indebtedness occurs when the taxpayer is insolvent, no income is recognized for federal income tax purposes. The IRC defines insolvency to mean the excess of liabilities over the fair market value of assets immediately before the debt discharge. Kasdan: How does a buyer preserve the NOLs in a bankruptcy sale? Cupingood: Section 363 allows for the court-‐approved sale of either the assets or the stock of a debtor corporation. The deal structure of the sale affects the
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immediate income tax consequences of the transaction to both the buyer and the seller. The buyer may prefer to keep the seller intact and to acquire stock to preserve the NOLs. If the buyer cannot use the debtor income tax attributes, then the buyer is likely to purchase the assets to get a stepped-‐up depreciable tax basis. Kasdan: At what point does a troubled company bring in a tax accountant? Cupingood: In the beginning, if possible, to figure out a tax advantageous structure of the transaction: stock v. asset sale. Blanco: The trouble is it may be expensive to bring in all the professionals. A quick tax assessment would be very helpful. Accountants are better at looking at the numbers. Cupingood: Most of the time we can do a quick and dirty analysis of what makes sense, whether it’s the NOLs, alternative minimum operating tax or other tax consequences. Many restructuring attorneys call us for a quick assessment of the situation. You want to know what the effect of selling a company is going to be. Kasdan: Is there a way to structure a Section 363 sale as a tax-‐free reorganization? Cupingood: You can structure a Section 363 sale as a tax-‐free reorganization under the IRC Section 368, an exchange of stock in a tax-‐free statutory merger. Kasdan: What are the tax considerations from the buyer’s perspective? Cupingood: Buyers typically want to buy assets. Some assets such as IP may have zero tax basis even though they have value. Buyer wants stepped up basis to amortize the assets over time going forward. Buyer may be willing to pay for some of the tax effects. Kasdan: In closing, I would like to reiterate that restructuring is a very complex and tough to navigate area. To execute a successful transaction, it is imperative to have a team of competent and experience professionals in place. It is imperative to bring in trusted advisors at the earliest sign of distress. In today’s environment, lenders are reluctant to work out underperforming credits. By the time issues are addresses, the companies may be beyond a turnaround. At an earlier stage, there may be multiple options that a competent investment banker can address, such as raising capital or shedding non-‐core assets. While the market could and expected to become more robust, deals are getting done and with the right structure in place and addressing all the right constituencies and players, these deals can be very interesting and generate significant returns.