The Evolution of the Liquidators Role in Restructuring Transactions

The Evolution of the Liquidators Role in Restructuring Transactions

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The operational model by which consumer products are liquidated has become the foundation on which an increasing number of retailers, wholesalers and manufacturers are financed. That model provides the underpinning for conclusions regarding asset values and borrowing capacity. The liquidation firms who have broken down this model are extremely knowledgeable and efficient. As execution has become more efficient and databases containing the results from past liquidations have grown, liquidation values have increased. Liquidators are bidding into higher recoveries, and therefore liquidation transactions have become more risky and potentially less rewarding.

At the same time that liquidation values have increased, enterprise valuations within several segments of the consumer products retail and manufacturing markets have decreased. The domestic textile industry and the recorded music industry provide stark examples of this phenomenon.

The intersection of values achieved by liquidation models and enterprise models has created new opportunities for liquidation firms. These firms have continued to demonstrate tremendous adaptability as they have invented new roles for themselves and new models for completing restructuring transactions. Here is a look at the role of the liquidator in restructuring transactions and how that role has evolved and continues to evolve.

The Development of the Liquidation Model

Prior to the last decade, the usual model in a bankruptcy-related liquidation transaction was for the liquidator to take title to the assets in a trustee's auction. The passing of title was often reflected by a trustee's bill of sale. Usually, these liquidation transactions yielded pennies on the original cost value of the purchased assets.

During the last decade, the liquidation business, especially in the consumer-products area, began to rapidly change. Liquidators began to hire restructuring professionals and senior executives from retailers with operational and merchandising expertise. Liquidation firms developed operational and financial infrastructures that allowed them to ramp up in a short timeframe in order to sell consumer products before carrying costs and loss of consumer demand eroded such products' value. This model has been layered onto a contract by which the liquidator is often appointed the agent for the trustee, thereby avoiding a transfer of title and the attendant liabilities.

The Liquidator and the Asset-based Lender

Tightened credit in the early '90s and several bank failures caused bank regulators and lenders to become more interested in understanding asset quality and tying loans to the liquidation value of the collateral that secured them. This represented a change from prior practice, where most commercial loans were underwritten based on an assessment of enterprise value and cash flow. Liquidation companies responded to these changes in the lending environment by forming their own finance companies that specialized in making asset-based loans to consumer products companies and by creating valuation services divisions to appraise the net liquidation value of assets securing asset-based loans.

Today, asset-based lenders regularly rely on net liquidation value appraisals to support the underwriting and syndication of their asset-based loans. In many cases, even where loan facilities are not strictly asset-based, net liquidation value appraisals are being performed to support underwriting and covenant decisions. Ultimately, these appraisals, whether related to inventory, real estate, equipment or intellectual property, provide the starting point for the determination of the advance rates that govern the amount of the borrower's borrowing capacity. Unlike the "highest and best use" style appraisals traditional in some areas like real estate lending, the appraisals provided by liquidators to asset-based lenders represent an opinion of value from a company generally prepared to transact on the terms set forth in its report. The explicit assumption underlying these valuations is that the theoretical liquidation will take place with the benefits and protections available under the Bankruptcy Code.

The symbiotic relationship among the asset-based lender, borrowers and liquidators has grown more apparent as liquidation firms have stretched the limits of their creativity in order to develop strategies for increasing the recovery on assets in liquidation and other restructuring transactions. A basic tenet of the liquidation model is that recoveries are maximized when assets are conveyed to the borrower's traditional end-users utilizing the platform from which those end-users are used to make their purchases. Utilizing this structure, liquidators have been able to support increasingly higher net recoveries. Indeed, in certain recent public bankruptcy auctions, guaranties from liquidators against the value of liquidated assets have exceeded 100 percent of the debtor's cost.

The Liquidator and the M&A Transaction

In similar fashion, the liquidator has now become an important player in M&A transactions involving restructuring companies. For several years now, strategic buyers have recognized the value that can be created from partnering with liquidators in connection with acquisitions. With their databases filled with information from past deals, practical experience and marketplace savvy, the liquidation partner is able to give the strategic buyer a true sense of an asset's value. Because the liquidator will typically be willing to invest in its valuation, the alliance creates an exit strategy for assets the strategic buyer does not want, while at the same time leveraging down the cost of the strategic buyer's investment.

Several recent examples illustrate the point. At the end of 2000, joan and david, a bankrupt designer, distributor and retailer of higher-end women's shoes and apparel, was looking for a buyer. One of its potential purchasers was Maxwell Shoe Co. Maxwell is an importer and distributor of shoes to department stores and specialty retailers. It is not itself in the retail business. By partnering with a liquidator, Maxwell Shoe was able to acquire the joan and david brand, create an exit strategy in respect of joan and david's retail stores and inventory, and leverage down its purchase price by participating in the upside generated from the liquidation of the retail inventory.

More recently, Trans World Entertainment, the operator of several hundred retail music stores, agreed to acquire the assets of Wherehouse Entertainment, a competitor. By partnering with a joint venture of liquidation companies, Trans World was able to structure its offer so that it paid a minimal premium over liquidation value, eliminated the unprofitable Wherehouse Records stores it did not want and cleaned up the inventory it acquired. In these and many other cases, the liquidator acted as a strategic partner to facilitate an M&A transaction.

The Liquidator as a Financial Buyer

More recently, liquidators have themselves become financial buyers of restructuring companies, thereby creating exit strategies for the acquired companies' managers or owners looking for a way out of challenged investments. In many respects, these acquisitions mirror recent transactions involving consumer products companies acquired by more traditional investment firms. For example, Musicland, the operator of several hundred music and video stores, was recently sold by its parent Best Buy to a private equity fund for one dollar. Laura Ashley, the UK-based retailer of higher-end women's apparel and home furnishings, recently sold its European stores to a financial buyer for two Euro. In both instances, the parents were looking for solutions to stop the ongoing cost of operating money-losing business units. Beyond red ink, these operations divert valuable management time and create negative perceptions in the capital markets.

In the first quarter of this year, Cablevision Systems Corp., the cable television and entertainment company, was wrestling with similar challenges to those faced by Best Buy and Laura Ashley. In Cablevision's case, it was its continued ownership of the consumer electronics retailer The WIZ, which Cablevision had acquired in a §363 sale in 1998. Following its acquisition, Cablevision had loaned or invested more than $450 million into The WIZ without turning it around. In February, Cablevision announced that it was forestalling further investment into The WIZ and looking for a buyer.

Enter GBO Electronics, a company formed by two liquidation companies. GBO acquired the stock of The WIZ for $10 and immediately implemented a plan to stop the continued cash losses being suffered by The WIZ. GBO retained experienced crisis management to manage the liquidation of The WIZ's assets, including its inventory, real estate and intellectual property. By drawing on the expertise of it shareholder's affiliates, the proceeds of the liquidation far exceeded anyone's most optimistic projections, while the costs attendant thereto were minimized. The WIZ recently filed its chapter 11 plan, which promises a meaningful distribution to all creditors.

This transaction had multiple benefits for all concerned. For Cablevision, it gave it a clean break from the continued cost and distraction from the management of its subsidiary's winddown. For The WIZ creditors, it maximized the distributive value from the company's assets and avoided the inevitable drain of asset value that is typical of protracted liquidations.

Many other companies are struggling with the management of money-losing or insolvent subsidiaries. Given the costs attendant to continued operation of those subsidiaries, creative approaches are called for. The WIZ transaction provides an outside-the-box solution that leverages off of the liquidator's ability to understand value, maximize liquidation recoveries and manage the wind-down process.

The Future

Liquidators continue to evolve to address changing market conditions. Leveraging off of their core competencies of understanding value and the restructuring process, liquidators continue to fashion creative solutions that maximize asset recoveries while minimizing expenses. The operating model that these firms have created provides a platform for financing, M&A and equity investment transactions. Given the margins at which liquidation auctions are currently being bid, we can expect more partnerships between lenders, strategic buyers and liquidators, and more instances in which the liquidator acts like a financial buyer for its own account.

Journal Date: 
Saturday, November 1, 2003