When a Private Company Leverages Up, Independence Matters

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Private-equity backed Payless ShoeSource investigates if certain dividends paid to the Company’s shareholders contributed to its bankruptcy filing. Find out how a company’s board of directors can help protect themselves in these types of matters.

Ever since the emergence of institutional private equity (PE), the owners of PE-backed businesses have relied on debt capital to fund a large portion of the capital structure of the companies that they acquire.   In fact, the PE investment model itself depends significantly on this leverage to increase returns to its investors.  This is due to the asymmetric nature of shareholder returns in highly leveraged businesses and the “fixed” nature of the debt itself – the more debt there is in the capital structure, the higher the returns to the business’ shareholders when the underlying value of the company increases, all else held constant.  Conversely, when the amount of leverage placed on these businesses increases, the risk to the shareholders when the company begins to face headwinds increases, as well.  Despite the fact that the underlying value of the business may be declining, the amount of the debt that needs to (eventually) be repaid has not changed.

In recent years, leverage levels have certainly increased.  According to Thomson Reuters, leverage levels in PE-backed leveraged buyout (LBO) transactions (as indicted by the level of debt to earnings before interest and taxes, or debt to EBITDA, at the time of the LBO) has increased from approximately 4.5x in early 2012 to nearly 6.0x in the first quarter of 2017.  While many would (rightfully) argue that leverage has not increased nearly as much on a relative basis (because the underlying value of businesses, as reflected by M&A multiples paid, has increased during this timeframe, as well), it cannot be argued that when the absolute level of leverage increases, the absolute risk to the business and its shareholders also rises.  And, as leverage levels increase, the amount of scrutiny that these deals receive when things don’t go well tends to increase, too.  Thus, it becomes even more important to ensure that these types of leveraged recapitalization transactions are subjected to a rigorous level of review by qualified, highly experienced professionals prior to their approval by a company’s board of directors.

Nowhere has this phenomenon played out more acutely in recent years than in the retail industry.  It is no mystery that certain (primarily smaller) traditional “brick and mortar” retailers in the United States have been under fire in recent years owing to the rapid emergence, and acceptance by consumers, of pure-play online retailers such as Amazon and the embrace of e-commerce by traditional market leaders like Wal-Mart, Target, Staples, etc.  Not surprisingly, this trend has hit the private equity (PE) community hard, as well, with more than 30 PE-backed retailers having filed for bankruptcy protection in recent years according to the PitchBook platform, including such well-known names as H.H. Gregg, Eastern Mountain Sports, and Gordmans Stores.  In many cases, these retailers were originally acquired by their PE sponsors using significant amounts of debt to help finance the LBO purchase price.  The lesson, in hindsight, of course: declining businesses and piles of debt are, generally speaking, a poor combination.

Now, in a possible case of more “self-inflicted” wounds, the creditors of one PE-backed retailer are alleging that a common strategy employed by private equity firms to return capital to their investors after a purchase – namely, the dividend recapitalization, or dividend recap transaction – is to blame for prematurely pushing the company into bankruptcy.  Dividend recaps result from using borrowed money to issue a special dividend to a company’s shareholders, often increasing the debt to EBITDA level beyond even what it was in the original LBO, or to a similar level, albeit on an increased value of the underlying business.

In 2012, several PE funds partnered to acquire Payless ShoeSource from publicly traded Collective Brands in an LBO deal.  In the years that followed, the company paid its PE sponsors roughly $350 million in cash dividends in aggregate via two separate dividend recap transactions that were financed through additional borrowings backed by the assets and cash flows of the business.  Once the business started to struggle, however (Payless has announced plans to shutter close to 10% of its over 4,000 stores globally), the company was no longer able to support its increased debt load, and it filed for bankruptcy protection earlier this year.

An official committee of Payless’ unsecured creditors is now alleging that the additional borrowings used to fund the dividend payments hastened the company’s decline into bankruptcy, and has asked the bankruptcy trustee to hire a financial expert to review the company’s pre-bankruptcy transactions, including the extraordinary cash distributions to its shareholders.  Ostensibly, the creditors are seeking to determine whether the distributions represented prohibited transactions pursuant to the fraudulent conveyance provisions of the Federal Bankruptcy Code as well as general state laws (e.g., the Uniform Fraudulent Conveyance Act). These laws cover not only intentional fraud by a borrower that is intended to financially benefit secured creditors or shareholders at the expense of unsecured creditors, but also “constructive” fraud. The Federal Bankruptcy Code defines constructive fraud as occurring when a debtor either: 1) was insolvent on the date the transfer was made or becomes insolvent as a result of the transfer; 2) was left with unreasonably small assets or capital as a result of the transfer; or 3) made the transfer with the intent to incur (or reasonably should have believed that it would incur) debts beyond its ability to repay them.

If the bankruptcy court were to find that a fraudulent conveyance did occur, the Payless dividend recap transactions could be unwound and the PE sponsors (and possibly other beneficiaries of the dividends, such as executives who may have received bonuses based on the payments) could be forced to return the transaction proceeds to the bankruptcy estate for redistribution to the company’s creditors.  In addition, the court can impose penalties, including judgments against an individual’s personal assets, on the principals that were found to have engaged in the fraudulent transactions, regardless of whether there was any malicious intent by the parties.

Payless, for its part, has asked the bankruptcy trustee to reject the creditors’ request, noting that the retention of an independent financial expert could slow down the company’s restructuring and hamper its efforts to emerge from bankruptcy with new financing later this year.  Instead, Payless has appointed an independent board member to undertake its own review of the transactions and assess whether the company may have any potential claims against its shareholders.

While it appears, at first blush, that the Payless board of directors followed standard protocol in assessing the financial impact to the company of the additional debt funding the dividend payments at the time these payments were made to the shareholders, the fact that they are now under a high level of scrutiny by multiple parties –   and an independent board member is investigating whether they contributed to the company’s current ills – illustrate the enhanced level of review that these types of highly leveraged recapitalization transactions should undergo prior to their approval.  Of principal importance in this review should be the engagement of an independent financial advisor to render a solvency opinion on the deal.  While such an opinion offers no guarantees, of course, it can assist a board of directors in fulfilling its fiduciary duties by not knowingly or recklessly approving a transaction that leaves a business insolvent.  It can also go a long way in helping the company, the directors, and the shareholders to fend off later challenges to the deal, such as the one currently being mounted by the Payless creditors.

Amid the increased scrutiny and risk of litigation in today’s market environment, fiduciaries need to hire qualified, objective advisors who can develop well-supported opinions during the transaction process and stand by them long after the transaction has closed. Specifically, for an industry such as retail that is continually changing, it’s even more critical to hire a financial advisor that has the industry expertise to understand the nuances of the retail industry and investment marketplace at any particular time.

Stout leverages its considerable investment banking and valuation expertise and retail industry experience to deliver opinions that can withstand scrutiny and assist clients in making sound business decisions. We understand the complexity and uncertainty inherent in completing a transaction and are committed to helping our clients navigate through the “noise” to provide timely, sophisticated, and reliable advice.  By utilizing our proven valuation techniques, sophisticated financial and cash flow modeling, thorough industry analysis, extensive due diligence, and experienced transaction opinion committee, we provide fiduciaries the assurance they need to prove the transaction has been diligently investigated and reviewed.

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Subsequent events: After the initial publishing of this article, Payless agreed to settle the dispute with its creditors over payment of the extraordinary dividends to its PE shareholders.  Pursuant to the settlement, the Company agreed to pay $25 million to its unsecured creditors (e.g., primarily creditors that it deals with in the ordinary course of business, such as trade vendors) as part of its bankruptcy reorganization, which corresponds to a recovery of roughly 20 cents on the dollar for these creditors.  This amount is substantially in excess of the amount that these creditors otherwise stood to recover in the bankruptcy, but allows Payless to put this dispute behind it and move forward with pursuing the financial restructuring with its senior secured creditors that it had previously agreed to.  Payless did not admit to any misconduct as part of the settlement agreement.