Transcript: Alternatives for a Distressed Company in Apparel and Retail

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The discussion includes the process of bidding for, financing and acquiring distressed companies in the Apparel and Retail space is competitive and complex. The panel addressed the strategies and tips …

The discussion includes the process of bidding for, financing and acquiring distressed companies in the Apparel and Retail space is competitive and complex. The panel addressed the strategies and tips for success from the perspectives of an investment banker, a deal and bankruptcy lawyer, a turnaround executive, a lender and a tax accountant.

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  • 1.     1         TRANSCRIPT:                   EVENT  SPONSORS:            
  • 2.     2         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  
  • 3.     3   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.  
  • 4.     4     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  
  • 5.     5   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  
  • 6.     6   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  
  • 7.     7   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.