Distressed investors may see value in individual assets held by a distressed company or pledged to its lender, rather than in the company as a whole. These investors see opportunity in these assets, but realize significant risk in acquiring them. To assume this risk, they seek a certain level of return. They are skilled in what they do, just as turnaround professionals are skilled in advising those suffering distress.
So, how is it that after things have gone horribly wrong and landed a company in distress, they sometimes go terribly wrong again when it comes to asset disposition? No one likes losing money, especially lenders, but when a loan, often an asset-based loan (ABL), has gone bad and is impaired, advisors and lenders alike often try to squeeze as much as they can out of the assets they have. Who can blame them? However, this thinking requires modification; as counterintuitive as it may seem, recoveries are usually maximized via a sale rather than through self-liquidation.
In an article on Harvard Business School’s website, professor Ananth Raman discussed a study of store liquidation strategies he performed with a doctoral student:
Two important facts came to light, says Raman. First, efficient liquidation enables efficient innovation simply by ensuring that new firms have room to enter the market. Second, efficient liquidation also reduces a retailer’s cost of capital by increasing the bank’s confidence that a retailer’s inventory can be used as collateral.1
Though Raman was speaking strictly about inventory, his observations apply to all assets of a company. ABL lenders dealing with a troubled loan have limited options: 1) a workout via a turnaround, 2) the sale of assets, or 3) self-liquidation of assets, normally through a professional advisor. Examining each of these options provides some context.
A number of retailers, including department stores, jewelers, and furniture stores, experienced multiple store closures over the past few years. Twelve companies alone accounted for a whopping 2,291 store closures.2 Many, though not all, of these retailers shared some commonalities in that their assets included inventory; receivables, whether their own or through a private label; real estate; and intellectual property. Some were complete liquidations, while others reduced their store counts and are still healthy companies.
Total liquidation, as in the cases of Heritage and Bon-Ton, best illustrates various scenarios. For purposes of this article, a fictional furniture company, Area Attic, is used. The company sold through 90 smaller-footprint outlets, but was also a wholesaler to more than 300 mom-and-pop furniture companies. Area Attic was owed $30 million by these third parties; had an in-house, near prime credit department with another $70 million in receivables, not including unearned interest; and owned inventory of $60 million (at cost) across all stores. It owned the real estate for its distribution center and its manufacturing facilities, including one in Indonesia and another in North Carolina. While there was work-in-progress at the factories, this exercise assumes little value for those components.
Area Attic was a storied firm, so there was ample interest in its intellectual property, which included its namesake brand, as well as its Belfry’s, Rafters, and Upper Floor brands. Due to failed strategies to sell hot tubs to seniors via a cellphone app and another targeting millennials with formal dining room sets, as well as a consistent problem with bats in its stores, Area Attic lost significant revenue and posted back-to-back yearly losses, breaching covenants with its banks. Fictional turnaround firm Loft Garret was retained and, with the company, determined that the best option was a total liquidation of all assets. Area Attic then filed for bankruptcy.
Before the filing, Loft Garret had conducted a well-publicized auction process to sell the company as a going concern, but there were no buyers for the business as a whole. The attempted sale garnered media attention, most of which was negative for the company, given that revenue streams also included extended warranties for its furniture products. In addition, the turnaround firm discovered problems via a Phase I environmental study for the facilities in North Carolina and concluded that Area Attic’s many leases were at or above market value. Nonetheless, bids were received for each of the asset classes (Figure 1).
There was no assumption of debt other than for the tainted real estate, for which the buyer offered to remediate the property. Secured creditors were owed $150 million and unsecured creditors were due $35 million. Loft Garret cost the estate $300,000 per month, and the firm estimated that ongoing bankruptcy and other nonbusiness administration costs would amount to $5 million. The commercial receivables would take six months to liquidate, while the consumer receivables would take five years. The bids for the receivables were for all of the receivables and were not broken out by class.
Proceeds of the sales only netted $132.5 million, and Loft Garret met with the banking group to decide what to do.
You can use all the quantitative data you can get, but you still have to distrust it and use your own intelligence and judgment. – Alvin Toffler
The analysis may seem straightforward: first, determine anticipated collections through self-liquidation. Loft Garret conducted an analysis with management and determined that, since there were no going concern bids, the sale prices for the IP and real estate were the best they could expect within the short timeframe in which they were working. Further, the negative publicity had greatly affected the value of the IP. Thus, they accepted those offers.
Self-liquidating with management in place did not net the estate much more than it would have realized had the company used a liquidator, which would have cost the estate $675,000. Self-liquidating is considered an inferior option because existing management is usually ill-equipped to manage and obtain resources needed for liquidation sales.
Collecting receivables, on the other hand, is a core competency of management, and the company and Loft Garret felt they could collect a net $80 million, thereby saving the banks $15 million against losses and providing the potential for those lenders to be paid in full and for unsecured creditors to receive some payment. The plan for the consumer receivables was to collect for the first 18 months and then sell the remaining portfolio, while the commercial receivables were to be collected in-house.
However, this reasoning is problematic and confuses objective and subjective concepts. What Loft Garret, the company, and its lenders failed to recognize was that collecting on receivable portfolios is as complicated as managing an inventory liquidation. Lessons can be learned from a real-life example of a consumer retailer bank group that followed comparable advice from a firm similar to Loft Garret. In that case, the inventory was liquidated over a period of four months, and the group decided to self-liquidate the receivables.
What they did not, and could not, know at the time was the impact on the charge off and payment rates due to the loss of the customers’ ability to shop at the store, as well as the failure to retain the better employees—those who best understood the customer.
Many consumers are fickle, generally unsophisticated, and unpredictable. Some, especially those with lower credit scores, often pay more on their balances to free up open-to-buy at the store where they have established credit. When the store closes, these consumers establish credit elsewhere and either reduce their payments to the store that closed or stop paying entirely. It is not unusual for these consumers to believe that a store’s closure somehow relieves them of their responsibility to repay their debt.
It’s prudent to assume that the charge off rate in any liquidation will increase two to three times and that the payment rate will fall, thus necessitating longer periods for collection. In one company, the charge off rate increased to five times the normalized rate. This is an example of an objective issue that Loft Garret should have taken into account, but was ill-prepared to do so.
In another real-life example, after a lender and turnaround firm decided a company should self-liquidate, the government changed a key regulation, in one day destroying how payments were made on accounts. Further, a number of state attorneys general sued the company for violating various consumer protection laws. The bank group erred because it failed to take into account that receivables do not collect out in the ordinary course in a store closing situation, just as inventory sales differ during a going-out-of-business sale.3
Area Attic was owed $30 million by other furniture sellers but had several obligations to its commercial customers, including repairing or replacing merchandise that was defective or damaged in shipment. Other manufacturers that sell to big box stores like Target or Walmart are subject to myriad offsets to receivables, including advertising allowances, returns due to sizing or other issues, disputes relating to what was ordered versus what was delivered—the list goes on. It is common for big box stores and others to slow payments, increase returns of product even after the stores have closed, and dispute more balances requiring proofs of deliver (PODs). Slower payments lead to increased costs and a need to retain employees and systems longer. The bottom line is a lack of certainty on actual collections.
Purchasers of troubled-company assets are accustomed to taking these risks, but are lenders or turnaround advisors? Closing stores, manufacturing facilities, or any other business requires a deliberate, methodical approach that includes determining when to consolidate or take additional markdowns, staffing levels, advertising, and similar issues. Receivables must be handled correspondingly.
Firms may overlook the complexity of discounting, systems, and settlement when it comes to receivables, especially in the commercial context. Yet these considerations are just as important as dealing with inventory or any other asset of the company. The following considerations are often ignored:
So, what is a lender to do? Should it outsource collections on a fee basis as is done with inventory? That is one viable solution when dealing with commercial receivables, but it needs to come with a guaranty of collection backed by a company with the financial wherewithal to pay if need be. This is not a practical option if the receivables are predominantly consumer receivables.
Should the lender sell to the highest bidder and move on? In most situations, yes. When a lender attempts to do something it and the turnaround firm may not completely understand, like liquidate receivables, costly mistakes can occur. It is common for the receivables company to continue the turnaround firm’s engagement to preserve continuity with customers and internal personnel.
When making a loan for which receivables are a critical part, it is essential for a lender to have a backup plan. That typically means having a backup servicer—often referred to as cold, warm, or hot, depending on how fast the lender may need to effectively flip the switch. The lender should get a receivables appraisal and update it periodically. Lastly, it should try to find the company’s weakest links, such as reliance on key regulations or customers. Is the company equipped to handle changes in its customers’ enterprise resource planning (ERP), for example?
As professor Raman observed, what at first may seem logical is not always the best option.