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BUYOUTS FROM FAILURE

Louise Scholes

Introduction

In times of recession there is always an increase in the number company bankruptcies (insolvencies) and therefore an accompanying increase in the number of management buyouts and management buyins¹ from these failed companies. Most buyouts from insolvency are purchases of parts of failed groups rather than attempts to rescue whole firms (Robbie et al., 1993; Scholes & Wright, 2009). A good example of this is the buyout of Denby from Coloroll. The parent company Coloroll ran into financial difficulties and was forced to sell Denby (see Case 2). The over-expansion of companies with debt-financed acquisitions when times are good is often the reason that these companies go into insolvency when times are not so good (Robbie et al., 1993). These failed companies have to shed their acquisitions, which are themselves often healthy entities. The acquired firms are then acquired again but by their own management team, an incoming management team, a private equity (PE)² firm, or a combination. Attempting to rescue whole failing firms may be a more complex task requiring significant strategic changes as well as management changes and restructuring. In these cases PE firms or incoming management teams need to have significant turnaround expertise if they are to succeed.

From a theoretical perspective buyouts have been explored mainly from an agency perspective but also more recently from an entrepreneurship perspective. The agency perspective of buyouts was initially proposed by Jensen (1989) and was based on PE buyouts of publicly listed firms. It suggested that agency cost reduction (i.e., the cost of persuading managers to act in the interest of owners) occurs as a result of three main changes that take place in a buyout. First, the management of the company become the new owners (along with PE firms) thus aligning objectives of owners and managers. Second, an increase in the amount of debt in the firm’s financial structure means they must become more efficient to service the debt. Third, PE-imposed governance changes to the board, monitoring by PE, along with new managerial incentives, are aimed at ensuring performance improvements. By contrast the entrepreneurship perspective (Wright et al., 2000) considers buyouts as a catalyst for entrepreneurial activity which has already been shown to occur in buyouts of family firms (Scholes et al., 2010) and divestment buyouts from larger firms (Meuleman et al., 2009). In the case of buyouts from the receiver, those from failed independent companies may require significant restructuring and improvements in efficiency so may fit more 187with the agency perspective of buyouts proposed by Jensen. Those from failed parent companies may or may not require efficiency improvements but will certainly also have the opportunity to develop their company in new directions as they become free of the constraints imposed by the former parent company.

The following sections look at the general characteristics of these buyouts, PE involvement, post-buyout performance, three case studies, future research, and finally a summary.

General characteristics of buyouts from failure

The trend in the number and value of buyouts from insolvency from 1985 to 2016, taken from the Centre for Management Buy-out Research database³ is shown in Figure 10.1. Buyouts from firms in insolvency initially peaked in the depth of the recession of the early 1990s, with 105 deals in 1991 accounting for 18.1% of the deal volume. A second, lower peak occurred in the much shallower recession of the early 2000s with 78 deals completed in 2002, accounting for 12.1% of deal volume. The deep recession of 2008 and 2009 saw a sharp increase in buyouts of companies from insolvency reaching 114 deals in 2009, accounting for this source’s highest ever share of the market at 28.7% of deals. The total value of buyouts from insolvency reached its highest ever level in 2012 at £1.8 billion (10.3% of total deal value), but it was also significant in 2005 and 2009, when value reached £1.15 billion and £1.13 billion respectively (4.6% and 18.6% of total deal value respectively).

The relationship between the UK recessionary periods and the proportion of buyouts from insolvency is shown in Figure 10.2. It is clear that the proportion of buyouts from insolvency (in relation to all types of buyout) increases during recessions (represented by the falls in GDP) as firms in the general population fail.

Buyouts of firms from insolvency have occurred across a wide range of industries, being most numerous since the late 2000s in manufacturing, followed by retail, technology, media, and telecommunications (TMT), and business and support services (Table 10.1). However, there are notable similarities between the earlier and later parts since 2000. The number of buyouts from failed firms in the TMT sector was high in the 2001–2003 period, reflecting the collapse of the dot.com boom, and high again in the most recent recessionary period (2008–2012). In the recent recession this was due to consolidation in the TV/radio/newspaper/magazine businesses as well as difficulties in the marketing sector. There are, however, some differences across the period, which reflect the consequences of recession – specifically, that buyouts of failed firms in property and construction, food and drink, and retail and leisure sectors have been particularly prevalent recently compared to previous years. The property market experienced a significant decline after the banking collapse in 2008 due to falling confidence in lending and borrowing. The increase in failures in the food and drink sector reflect more selective buying that occurs in a recession particularly on necessities such as food. The increase in failures in the retail and leisure sectors is symptomatic of a fall in discretionary spending typical in recessionary times (Flatters & Willmott, 2009).

Figure 10.1      Buyouts of failure firms in the UK

Source: CMBOR/Equistone Partners Europe/Investec Bank.

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Figure 10.2      Source of buyouts from failed firms versus GDP⁴ in the UK

Source: CMBOR/Equistone Partners Europe/Investec Bank.

Table 10.1      Sector distribution of buyouts from failed firms in the UK

189Figure 10.3      Buyouts versus buyins of failed firms in the UK

Source: CMBOR/Equistone Partners Europe/Investec Bank.

Table 10.2      Average deal structures for all UK buyouts, compared to PE-backed buyouts from failing firms (in parentheses)

The majority of buyouts of firms from insolvency tend to be of the buyout type where the firm is bought by incumbent management. For example of the 69 deals from insolvency completed in 1990, the majority (92%) were buyouts rather than buyins. There is some evidence here that during recession the proportion of buyins increases and this could partly be due to an increase in the number of PE-backed deals (see Figure 10.3).

There is some evidence that PE-backed deals from failure have a greater proportion of equity in their deal structures and a lower proportion of debt compared to all buyouts, and that other types of finance like mezzanine and loan notes are not as likely to be used (Table 10.2). 190Certainly, obtaining the traditional types of debt finance may be more problematic when firms are failing. PE firms may also prefer to invest in failing companies with intangible assets such as brand names or lists of customers, rather than/or in addition to physical assets, but there is no data yet to suggest that this is the case.

For the buyouts from failure (in parentheses) there is little data on structures, and only means from three or more data points have been included.

PE involvement

Failed independent firms, or firms attached to failed parent companies, present an opportunity not only for the incumbent management but also for PE firms to buy the company. This could be important for PE firms if they need to do deals, they still have funds to invest, but other sources of deals are hard to find (e.g., from family firms or divestment buyouts or de-listings from stock exchanges). For example traditional larger divestment-type deals could dry up in periods when debt is difficult to arrange (e.g., the recent recession). Larger deals may not be so easy to complete so smaller deals from insolvency may help to fill the gap. There is also a great deal of potential for PE firms in cases where the parent company is in trouble but the subsidiary is healthy, as was the case for Kingsmead Carpets (Case 1).

The problem of information asymmetry for PE firms exists, the PE firms do not have the same information as the incumbent management team, but if they are dealing with a healthy firm that was possibly constrained by the parent, there is a great deal of scope for improved efficiency and entrepreneurial activity (Wright et al., 2000; Meuleman et al., 2009; Scholes et al., 2010). In terms of buyouts of independent failing firms the experience and skills of the PE firm are even more important. Some PE firms not only provide finance and monitoring, as traditionally has been the case, but some also now have particular expertise in restructuring and turnarounds and it is these companies that will be most likely to succeed in turning failing companies around. For example Epic Private Equity (Case 3) is not only an equity provider but also an advisor to other PE firms. It can thus provide expertise on the restructuring of the businesses it buys, as well as to other PE firms. Endless LLP is another example of a PE firm with turnaround expertise and refers to itself as a “transformational private equity investor.” It acquired Jones Bootmaker, one of the oldest brands in the shoe industry, for £11 million, in a so-called pre-pack deal in March 2017, an example of a failing independent firm that has to be restructured. The ability of PE firms to effect successful turnarounds is key to their successful involvement in all buyouts from failure but particularly in buyouts of failing independent companies.

According to CMBOR data, PE firms were most active in buying failing firms during the recessions of the 1990s, when there was a good supply of firms in insolvency and where bargains were to be found (Figure 10.4). In other periods, most noticeably since the end of the 2000s, PE firms have not been the main purchasers of these target firms. Nevertheless there is some evidence that during the most recent recession, PE firms were able to take advantage of the situation by buying failing companies (the proportion of PE-backed buyouts increased in the years 2012–2014).

The rise in the proportion of deals backed by PE firms in recent years may in part be due to the introduction of pre-pack deals (pre-pack administration) (Walton, 2009). Prepack deals appeared in the UK with the introduction of the Enterprise Act 2002, which was intended to be a mechanism where management could take over an insolvent company, allowing a firm to be sold to a new buyer as a going concern before the traditional administration process takes place, thus making the deal more favorable for PE firms. This speedy process prevents a company from being devalued by news of financial difficulties that could affect customer and supplier loyalty and patronage. The proponents of pre-pack deals say that they speed up the process and save jobs, whereas critics suggest that creditors, particularly unsecured creditors, lose out but that the buyers, often the same managers, are able to buy back the more profitable assets at a knock-down price. This is in addition to the incentive managers already have to buy their own company, due to information asymmetries about the firm between themselves and the vendors, which may enable them to buy the firm at a price that is possibly too low. The pre-pack buyout for Jones Bootmaker was completed very quickly by PE firm Endless. It saved the majority of the 1000 jobs and nearly half of the firm’s 170 stores, but all of its creditors lost out, unsecured creditor losing out the most. Some research suggests unsecured creditors get 1% return compared to 42% return for secured creditors (Frisby, 2007). Critics say that company directors are using pre-packs to get rid of large debts, unwanted shops, and even pension schemes.

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Figure 10.4      Buyouts from failed firms in the UK

Source: CMBOR/Equistone Partners Europe/Investec Bank.

Post-buyout performance

Although it is too early to assess the effects of buyouts from insolvency in the current recessionary period, our survey evidence from the last deep recession of the early 1990s, using a representative sample of 64 buyouts from insolvency, completed between 1990 and 1992, shows that major restructuring activities were needed to turn around the business (Robbie et al., 1993).

The study showed that the principal cause of insolvency was parent company related, including working capital failure, trading performance issues, acquisition policy, and market collapse (in the Whittard case performance issues and market collapse were dominant). Almost two-thirds (64%) had appointed new directors, 56% had not reappointed existing directors, 48% had reduced debtor days, 38% had reduced their vehicle fleet, and 34% had cash flow problems post-buyout (Table 10.3). The average employment level fell from 202 on buyout to 158 at the time of the survey. However, some 63% had not made job redundancies on buyout.

Between the buyout and the survey, 36% reduced employment further, 36% did not change employment levels, and the balance reported increases. In addition, in 19% of cases, 192employment was above pre-buyout levels. Over a third of the firms in the sample had cash flow problems mainly because of failure to reach profit targets and large capital expenditure requirements, both outcomes indicative of corrections needed after the constraints imposed by failing parent firms. In a general assessment of performance, 75% of cases reported reasonable or good performance one year after the buyout. This raises the question of the importance of buyouts for acting as a catalyst for entrepreneurship and innovation activity (Wright et al., 2000). Current evidence is consistent with buyouts, i.e., incumbent management exploiting growth opportunities after being freed from the bureaucratic control of the parent company (Wright et al., 2000; Bacon et al., 2004). It highlights the differences between buyouts and buyins, the significant heterogeneity that exists among buyouts, and aligns with the earlier evidence already discussed suggesting that buyouts are possibly management buying their healthy company from a failing parent, whereas buyins may be external management (possibly PE firms alone) buying whole failing companies that are not particularly healthy entities needing significant restructuring post-deal.

Table 10.3      Actions on or post-buyout (n=55–64)

In terms of the subsequent failure of buyouts from failed firms, evidence from deals completed between 1990 and 2005 shows that buyouts of firms from insolvency are slightly more likely to fail again than buyouts from other vendor sources. Taking all buyouts that failed up until June 2016, 24.5% of them were from insolvency originally compared to 22% from family/private, 17% from divestment buyouts, and 19% from secondary buyouts. However, when dividing the sample into PE-backed versus non-PE-backed there is a noticeable difference. PE-backed deals from insolvency are significantly more likely to fail again as are PE-backed deals of private/family buyouts (Table 10.4; Figures 10.5 and 10.6). Some reasons which help to explain this evidence are issues of information asymmetry and moral hazard for the incoming PE firms, along with a greater tendency to incorporate debt in the deal structure which may have repercussions in downturns when turnovers can fall. Some PE firms may also not have the specialist skills to turn companies around.

193Table 10.4      Failures of buyouts from different sources (in the UK)

Source: CMBOR/Equistone Partners Europe/Investec. Statistical significance: **p < .01

Note: deals completed 1990–2005, exited by June 2016.

Figure 10.5      Creditor exits by source, non-PE-backed

Source: CMBOR/Equistone Partners Europe/Investec Bank.

Note: for example 36 deals completed in 1992 had creditor exits and 9.4% of these were sourced from insolvency.

Case studies

Case 1: Richards Group – Buyout to save parts of the company

Richards Group plc, a publicly quoted Aberdeen-based carpet manufacturer, went into insolvency in January 2002 after management disagreements and failed attempts at restructuring. It spawned several buyouts/buyins of parts of the company. Kingsmead Carpets based in Cumnock, Ayrshire, was sold to its management team saving 60 jobs. The sales and marketing director stated at that time that “Kingsmead used to be part of a large group which restricted who we could deal with and the products we manufactured. Now we are an independent we expect to be able to grow more quickly.” The Northern Irish operation was sold to its management team and the Yorkshire-based floorcoverings subsidiary was subject to a trade sale. The remnant of Richards Group plc was sold as a management buyin to a local entrepreneur saving 145 jobs.

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Figure 10.6      Creditor exits by source, PE-backed

Source: CMBOR/Equistone Partners Europe/Investec Bank.

Key lessons:

Management buyouts are a means of saving a firm and saving jobs.

Buyouts can act as a catalyst for entrepreneurial activity, particularly when it is the parent company that has failed (the entrepreneurship perspective).

Case 2: Denby – PE-backed buyout from an insolvent parent

The case of Denby highlights what can happen when a large parent organization goes into insolvency. A management buyout provides a means by which more viable divisions, like Denby, can survive. Denby was targeted by management and PE firms when the parent firm went into insolvency. It also became a target of later buyouts due to performance difficulties from over-expansion combined with difficulties in repaying debt (as a result of former buyouts).

Denby is a world-famous British pottery manufacturer based in Denby, Derbyshire, which started producing pottery in 1809. In June 1990, Coloroll, Denby’s parent company, went into insolvency and Denby was purchased by its own management, backed by PE firm 3i, for a total of £7.4 million. Denby’s managing director and three associates invested £140,000 for a 55% stake in the company, while 3i held the balance.

The firm began to sell its products in the US, and by the time it floated on the London Stock Exchange in 1994 it was valued at £43.4 million. It used some of the proceeds of the sale to repay its debts and continued its expansion abroad, updated its range of products, and opened a visitor center complex at Denby. The center became a major tourist attraction, with 300,000 visitors a year by the end of the century.

The company has since undergone many more management buyouts: the second in 1999 for £40.7 million involved a delisting from the stock exchange; the third in 2004 for £48 million was a management buyout. More recently, the firm had difficulty servicing its debts in tough retail conditions (particularly for the UK pottery industry) and had its fourth buyout in 2009 for £30 million led by the managing director and PE firm Valco Capital Partners, a specialist in restructurings. Half of the group’s £72 million debt was written off as part of this transaction. Denby has added glassware and porcelain to its product range and continues to trade.

195Key lessons:

Provides evidence of successful buyouts of more viable parts of failing businesses.

Debt, often associated with PE-backed buyouts, can be problematic in times of recession.

PE firms with the necessary restructuring skills to turn companies around are crucial.

Case 3: Whittards – Pre-pack deals and successful buyouts

Whittards of Chelsea provides an example of a deal using a pre-pack administration arrangement. It became a target for PE firms when profitability was poor and the recession hit its main financial backer. Whittards is a tea and coffee importer retailer and was established on Fleet Street (London) in 1886 by Walter Whittard. Timing was perfect as two years later tea that had been grown in India flooded into the UK. The firm remained in family hands until 1973 when it was sold to two PE firms for £2.2 million, eventually being listed on the AIM Stock Exchange in 1996 when the PE firms exited the business. After the flotation and accompanying equity injection, Whittards began to expand, building up to 120 stores in the UK and adding new retail capability through Kitchen Stores and factory outlets. It opened up tea bars called T-Zone in response to coffee outlets such as Starbucks and Costa Coffee with observers suggesting that this was too late and that they did not respond quickly enough. The firm also had a disastrous foray into internet selling with the cost of doing this far outweighing the profit from it. By 2001 the firm was having financial difficulties. They had some management changes, got rid of the internet side of the business, and started to focus again on the core tea and coffee business. After forming partnerships with retailers in the UK and the US (large supermarkets), they regained profitability temporarily. Whittards, still a listed company, was quickly struggling again financially and was bought by an Icelandic investment company Baugur Group in 2005 for £21 million, but in 2008 Baugur Group was hit hard by Iceland’s financial collapse going into administration itself in that same year. Whittards was finally sold to Epic Private Equity in a pre-pack deal in 2008 for £0.6 million. Major restructuring has since taken place with the installation of a new management team, closure of 51 unprofitable stores, and improvements in in-store operations, point of sale, and merchandizing.

Key lessons:

Pre-packs can be used successfully as a means of buyout of a failing independent firm.

Independent failing firms are subject to efficiency improvements as a consequence of a buyout (the agency perspective).

Future research

Relatively little is known about buyouts from failed firms, so future research can be focused in several areas. Some of the suggestions here reflect the fact that buyouts are a very heterogeneous group, and there are substantial calls in the literature to recognize heterogeneity and context in this and other business-related fields of study (Zahra & Wright, 2011; Alperovych et al., 2013).

First, data shows that PE firms are not as successful at buying failed companies compared to management teams with no PE. Buying failed firms, especially during a recession, provides a great opportunity for PE firms to invest, and they are perhaps not making the most of this opportunity. What type of specialist turnaround skills are being employed, should this be different, and how do they overcome the problem of any limited time to assess the 196deal? In such situations what are the most valuable skills, are there any advantages to having relationships with the wider stakeholder community such as customers and suppliers, and would some form of legislation make a difference? Do they have in-house turnaround skills or do they have a network of turnaround specialists that they can use? Are any differences in shorter- or longer-term performance associated with the type and structure of the PE firm?

Second, what is the impact of pre-pack deals on buyouts from insolvency? Has this boosted the number of transactions, and, if so, what are the main factors associated with these deals that lead to easier transactions, and how controversial are they? Do deals arising from a pre-pack arrangement have a greater chance of success than others over time, what type of restructuring is involved, and does this give firms scope for growth over the longer term through capital investment, R&D, and innovation?

Third, there is little research on the type of entrepreneurial or innovation activity once the deal has been completed. Is it just firms that are bought by incumbent management teams that are innovative, just those that separate from a failing parent, and, if this is the case, what type of innovation do they engage in; is it exploitation or exploration (He & Wong, 2004), radical or incremental (Wright et al., 2000, 2001)? How well equipped are these firms to participate in different forms of innovation after potential serious constraints by parent companies, and what is the role of PE firms in entrepreneurship/innovation in these firms?

Fourth, there is certainly scope for a greater understanding of the differences between buyouts of a firm from a failed parent versus a buyout of a failed independent company. What are the performance differences between these two types of buyout from failure over time and especially during and after a recession? Does this relate to the health of the business at the outset, the extent of restructurings, the amount of debt, and what is the role of PE firms if they are involved?

Fifth, there is pressure on PE firms to use funds and invest in deals. Might there be a pecking order of deals? First, primary deals; second, if there is a lack of primary deals PE firms will invest in secondary buyouts; finally, if there are then insufficient secondary buyouts, will PE firms look at turning around failed businesses? Could investment in failed firms be a high risk part of a portfolio? Primary and secondary deals represent a lower risk part of the portfolio of investments while investment in turnaround is high risk. Do the potential rewards make it attractive to have a high-risk element in a portfolio of investments?

Sixth, there might be other general features of deals that are worth exploring. For instance, are PE targets from insolvency more likely to have physical assets or intangible assets (e.g., a list of customers or a trade name) since it might reduce the risk of the deal to the PE firm if these are valuable if the turnaround is unsuccessful? What are the sources and structure of finance for such deals? Presumably it is harder to secure loans, so does this mean that more equity is used in the deal? We have some evidence that the PE-backed deals have less debt and more equity, but this requires further investigation.

Finally, are MBOs from receivership more likely in regions where managers have fewer opportunities to find alternative employment? Are MBOs more likely in specific industries where managers have skills that cannot be easily transferred to employment in other industries?

Conclusions

Buyouts of distressed companies, whether in bankruptcy proceedings or close to them, are an important feature of the buyout market in general. These deals tend to come from viable parts of failed parent companies rather than failed independent businesses. They occur 197across a wide range of industries and are more prevalent during and just after recessions where supply is greatest. Reduced discretionary spend in times of recession can lead in particular to failures in the retail and leisure industry providing opportunities for management teams and PE firms to buy these companies at significantly reduced values. Management teams and PE firms with the right skills can take advantage of recessions and can, in doing so, help to stimulate the economy by rescuing ailing companies and even save national treasures like old-established former family firms such as Whittards and Denby (Cases 2 and 3). The majority of deals from insolvency are buyouts rather than buyins, an indication that the majority of deals are firms bought out by their own management from a failing parent. PE-backed buyouts from failure increase slightly during recessions but on the whole make up the minority of this type of deal. The main reasons for the failure of the group/independent company are working capital failure, trading performance issues, acquisition policy, and market collapse. Post-buyout performance suggests that not all of these firms reduce employment; in fact this happens in only just over a third of cases. Among all of the PE-backed buyout failures, those from already failed companies make up the largest proportion and this proportion is significantly higher than for non-PE-backed deals.

Failing companies can be bought at discounted prices (enhanced recently by the introduction of controversial pre-packs), and if they involve viable parts of failed groups, it may be possible to make a purchase that is free of major parent liabilities giving the new firm a good chance of becoming a profitable business once again. These firms are often bought by incumbent management. Buying failed whole companies may be more complex, and it is possibly the case that PE firms are more likely to be involved in this type of buyout which may also explain why PE-backed firms from failed companies may be more likely to fail again. In these cases there will be a requirement for significant restructurings, changes in management teams, and changes in strategy in order to effect the turnaround successfully.

For both types of buyout from insolvency (whether from a group or independent), there is a need for considerable turnaround activity both on buyout and subsequently if a viable entity is to be created and maintained. PE firms can take advantage of the increased supply of failing firms during recessions provided that they have the necessary financial and management skills to turn the businesses around. In addition to finance and management skills, PE firms buying out failed companies will need to make investment decisions much more quickly than is generally the case, often with less scope for due diligence and with few, if any, warranties. There is a premium on PE firms that have expertise in a particular sector and experience of distressed deals that enable them to make a rapid assessment of prospective risks and returns.

“Timing is always tight … buy it in 4 weeks or company might run out of cash.”

(John M. Collard, Chairman, Strategic Management Partners, Inc.)

The issue of timing and possible lack of crucial information may explain why among all of the PE-backed buyout failures, those from already failed companies make up the largest proportion. The more recent use of controversial pre-pack administration arrangements may make subsequent failure less likely for PE firms as the firm can be sold as a going concern before creditors are repaid. It is also important during this process to assess the calibre of incumbent management. If they are not a contributory factor to failure, their knowledge of the business may be crucial in avoiding any future pitfalls.

In the UK the number of PE firms that have very specific turnaround expertise has been increasing since the late 2000s, so this, combined with the advent of pre-pack administrations, may mean more buyouts from insolvency for PE firms and management teams in the future, and improved chances of longer-term success of these deals, along with more controversy.

198Notes

  1    From now on referred to as buyouts unless otherwise stated.

  2    From now on private equity is shortened to PE.

  3    The Centre for Management Buy-out Research (CMBOR), Imperial College Business School, London.

  4    The annual growth in GDP is taken from the OECD (OECD. Stat).

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