Monday, September 30, 2013

Rue21: A Deal to Rue

Yield hungry investors have swarmed syndicated leveraged loans this year. It seemed that they were throwing caution to the wind. Anything and everything seemed possible. Then came Rue21-one of the biggest high profile deals to flop in a while. Rue is a rapidly growing value orientated teen apparel fashion retailer. It has added 500 stores over the past years, and is scheduled to reach 1000 stores by year end.

In May, Apax, a UK private equity firm, offered to buy Rue for $1.1B Acquisition with a $62 Mln breakup fee. An affiliated Apax entity already owned 30% of Rue. The offer represented $42 per share- a 23% premium to market, 1.2X sales and 9.2X EBITDA. Comparable multiples were 0.5X sales and 8.4X EBITDA. The premium represented Rue’s rapid growth potential.

Apax would contribute $280 Mln in equity with the balance financed by debt representing a FD/EBITDA multiple over 6X. The debt included a JPMChase, BofA and Goldman $530 Mln syndicated loan. The loan was richly priced at L+ 475 with a 1% LIBOR floor.  During the syndication, Rue announced disappointing sales and earnings due to a “challenging retail environment”. Same store sales fell 9.5% thru 3Q and by 12.8% in September. The syndication struggled, and the agents offered 20-25% discounts without success.  See Syndication.

Some observations:
1)  Aggressive leverage for a rapidly growing firm is always a challenge. Add in fashion retail and the margin for error is razor thin.
2)  The purchase price was rich leading to the need for increased leverage. It only made sense assuming Rue’s growth would continue.
3)  Unexpected performance issues during the syndication are always possible. Nonetheless, I wonder how unexpected this really was. First, simple extrapolation, which appears to be the case here, is dangerous when constructing projections for growth firms. A modest downside case would indicate how problematic the debt service would be if a slowdown occurred.
4)  Basic earnings quality analysis also suggested concern. Earnings are an opinion while cash is a fact. Despite Rue’s growing sales and net income since 2009, their free cash flow peaked in 2011, and fell in FYs 2011 and 2012.  Growth related, rapid CAPEX and inventory increases were part of the problem. This coupled with a performance decline suggests a) Rue must curtail its growth and b) Rue will have difficult time repaying its debt. Loan investors undoubtedly saw this, and declined to participate despite the original rich price and even with the substantial discount -  they would not bite.

Diminished growth means the purchase price and capitalization rationales are no longer valid. Apax should consider renegotiating the deal or walking away after paying the breakup fee. The banks would be happy. Rue’s current shareholders, of course, would be upset, but would still be $62 Mln richer. Discretion is sometimes the better part of valor.


PS - Just over two months until Acquisition Finance in Amsterdam (see side note or click here)

Thursday, September 26, 2013

Divestitures, Who, What, Why and What Happens?

One of Joe's previous posts, The Power of Subtraction,  discussed the value that can be created by divestitures.  This leads to several interesting questions: Which firm divests?  When a firm divests, which division is sold?  What are the important factors in selecting that division?  How important are financial constraints in the divestiture process? And How well do divesting firms perform?  The abstract below describes a paper two colleagues and I wrote to analyze these issues. 

Asset Liquidity and Segment Divestitures

Frederick P. Schlingemann
University of Pittsburgh - Finance Group; Rotterdam School of Management (Erasmus University)
Ralph A. Walkling
Drexel University – Executive Director, Center for Corporate Governance, Lebow College of Business; Professor Emeritus, Ohio State University
Rene M. Stulz
Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

We investigate a sample of firms whose number of reported segments falls by one or more for the first time in their reporting history. The firms in our sample have a significantly larger diversification discount, underperform, and underinvest relative to comparable firms. Firms are more likely to divest segments from industries with a more liquid market for corporate assets, segments unrelated to the core activities of the firm, poorly performing segments, and small segments. The liquidity of the market for corporate assets plays an important role in explaining why some firms divest assets while others stop reporting them without divesting them, and why some firms divest core segments while others divest unrelated segments.

The final version is published in the Journal of Financial Economics.  A slightly earlier version of the complete paper can be downloaded here.

All the best,


Monday, September 23, 2013

Ronald Coase: Theory of the Firm and Too Big to Fail Banks

The danger of too big to fail (TBTF) banks is well known. The question remains concerning why do they exist and what can be done about it. External break-up and capital solutions have failed. They have been defeated by well financed lobbing efforts. Hope for a market based solution building on the work of the late Ronald Coase is beginning to take shape.

According to Coase, firms exist because they reduce transactions costs compared to other forms of activity. There is a limit regarding what firms can produce internally. Once reached, performance suffers, and the firm is pressured to refocus to improve returns. For banking that limit has been reached for the TBTF banks as reflected in their mediocre returns. These institutions are not only TBTF, but also too big to manage. Evidence is provided by the almost daily revelation of operating problems and litigation.

By all rights, they should restructure. Inhibiting this effort is the offsetting funding subsidies TBTF banks receive from the government. The increasing legal costs of TBTF may be offsetting enough of the subsidy to encourage a voluntary break-up of the TBTF banks. See my attached American Banker article on this matter.