Cover Story – Scouring for Pearls in Bankruptcies

Companies in bankruptcy historically have been the untouchables of the market for corporate control. Chapter 11 usually was a stigma for distressed merchandise and only the gutsiest acquirers were willing to navigate the often-labyrinthine process for springing the occasional rare gem from the corporate discard pile. No more. Increased numbers of both strategic and financial buyers are scouring for pearls in the one-time no man’s land – and frequently harvesting them at bargain prices. Although acquisitions of all or parts of financially beleaguered companies operating under bankruptcy court protection from creditors are not new, anecdotal evidence and recent statistics suggest that the volume of such cut-rate deals is on the upswing. Nearly four dozen transactions involving companies operating in Chapter 11 were completed in 1999 and a spate of others – headlined by McDonald’s Corp.’s plan to buy the onetime glamour stock gone south, Boston Chicken Inc. – were in the works in early 2000. Myriad reasons stimulate the ardor for bottom fishing at the hazardous lowest tier of the m&a marketplace. Buyers that run the gauntlet of steel-nailed creditors eager to be made whole and eagle-eyed bankruptcy judges may bag at a low cost a respectable operation whose principal sin was financial overreaching. Many bankruptcy courts invite acquisition offers for companies in their domain to telescope the marathon process for getting them back on their feet. And a huge number of private equity-based “phoenix funds” – some 200 by recent estimates – have been formed to buy and resuscitate troubled businesses, including those operating in bankruptcy. In sum, they add up to potential for real value creation. Joel M. Walker, head of the Creditors’ Rights and Bankruptcy Practice at the Pittsburgh-based law firm of Doepken Keevican & Weiss, says that not only may the price be right but that the “buyer can end up with the cleanest kind of business” because the acquisition plan typically includes discharge of the target’s debts. Michael Madden, principal at Questor Management, which specializes in turnaround acquisitions, takes a “more liberal view of the acquisition landscape,” claiming that “pickings have become slim and more expensive over the last decade” in the mainstream m&a market. “If we can buy distressed assets cheaper than building them, even with the risks associated with the acquisitions, it’s worth it,” he says. Daniel Morris, head of the turnaround management firm of Morris Anderson & Co., adds that increased sophistication has led buyers to put Chapter 11 firms on their radar screens. “The savvy players, the smart buyers, including financial acquirers, have figured out how to obtain solid core businesses even in bankruptcy,” he states. “Along with the business frequently come assets, free and clear of encumbrances, available for financing by a buyer.” One of the key elements that buyers have mastered, they agreed, is the realization that deals won’t fly on price alone. The best outcomes leverage the low going-in cost with a sound business plan for increasing value. McDonald’s, for example, bought enormous flexibility by swallowing up Boston Chicken in a purchase that straddles the line between a real estate deal and a strategic transaction. For a relatively modest $173.5 million, a sum that McDonald’s said was worked out with senior creditors, the hamburger chain bought rights to the Boston Market name plus 751 restaurants and franchises for another 108 units. Many analysts figure that McDonald’s was tempted more by an opportunity to buy sites on the cheap for recently acquired diversification projects in Mexican foods and pizzerias than by restoring the luster at Boston Market. When the deal was announced last December, Jack E. Greenberg, chairman and CEO, indicated in a carefully worded statement that McDonald’s could go either way. “The brand (Boston Market) is well-established, with excellent employees, quality products, loyal customers, and future growth potential,” he said. “Selected sites, where appropriate, will help support domestic restaurant growth for McDonald’s and accelerate opportunities for Chipotle Mexican Grill and Donatos Pizza over the next few years.” Other companies in bankruptcy involved in recent acquisitions and divestitures include: Filene’s Basement Corp. – Discounter Value City Department Stores Inc. agreed to acquire the much-shrunken off-price apparel merchant for $12.5 million and assumption of liabilities, which brought the total price to $89 million. A primary attraction is the legendary name that can be leveraged for a revival of the business, which was down to 14 Filene’s Basement stores at the time of the acquisition. Just For Feet Inc. – Athletic footwear retailer Footstar Inc. agreed to buy a huge chunk of the rival retailer – including 79 superstores and 23 specialty retail stores – for $69.7 million. Footstar said that the new units will “significantly accelerate the company’s long-term growth rate.” Harnischfeger Industries Inc. – The machinery firm dismembered its Beloit Corp. paper machinery sub and sold the parts piecemeal to three foreign buyers. The paper aftermarket and roll covers division went to the Valmet Corp. unit of Helsinki-based Metso Corp.; the paper technology operations to Mitsubishi Heavy Industries Inc.; and the pulp and finishing divisions to Groupe Laperriere & Verrault Inc., based in Trois-Rivieres, Quebec. Harnischfeger’s remaining businesses include surface and underground mining machinery. United Cos. Financial Corp. – The consumer and mortgage loan company agreed to sell its financial assets to EMC Mortgage Corp. Martin Color-Fi Inc. – The producer of polyester fibers and pellets from recycled plastics reached an agreement to be acquired by Dimeling, Schreiber & Park, a Philadelphia-based investment firm. Charter Behavioral Health Systems LLC – The psychiatric services firm plans to sell its 37 hospitals to real estate firm Crescent Operating Inc. as the key part of its reorganization plan. American Pad & Paper Co. – The office products maker is trying to sell its Williamhouse stationery division. Ambassador Eyewear Group Inc. – The optical goods firm wants to sell its assets to Marchon Eyewear Inc. Tanner’s Restaurant Group Inc. – Restaurant Teams International Inc. bought Atlanta-area Tanners for an undisclosed amount of cash and expects a fast payoff. Curtis A. Swanson, CFO of Restaurant Teams, said the company expects Tanners to contribute $9 million in sales, $1.2 million in EBIT-DA, and 10 cents a share in earnings. Tultex Corp. – Once a high-flying active wear manufacturer, the company has decided to liquidate by selling its remaining assets, which include an idled Virginia plant and a distribution center. More deals involving corporate casualties may be on the way. A sampling of well-known companies currently operating under the Chapter 11 shield includes: * Fruit of the Loom Inc., the apparel manufacturer best known for its men’s underwear and its eponymous powerhouse brand, which is heavily licensed. * Babcock & Wilcox Co., an energy equipment manufacturer and subsidiary of McDermott International Inc., which sought court protection while it tried to settle asbestos liability claims. * AmeriServe Food Distribution Inc., an institutional food distribution concern. * Eagle Food Centers Inc., a supermarket chain in Iowa and Illinois. * DecisionOne Holdings Corp., a provider of computer maintenance and technical support services. * Jitney Jungle Stores of America Inc., an operator of convenience stores and gasoline stations in the South. * ContiFinancial Inc., a mortgage lender which said it has been holding talks with interested bidders for its assets. * Ventas Inc., a health facilities real estate company. * Vencor Inc., which operates nursing homes and hospitals. * KCS Energy Corp., an oil and gas company. * Texfi Industries Inc., a textiles firm. * Geneva Steel, maker of steel products. * Tops Appliance City Inc., a New York-area discount merchandise chain Except for ContiFinancial, none of the above has hinted publicly at a sale – the implication being that they hope to reorganize and reemerge from Chapter 11 as independent entities. But the odds may be long for several. The list is studded with second-tier players in highly competitive, consolidating, and restructuring industries – e.g., retailing, wholesale distribution, textiles, steel, health care – conditions that drove them to seek bankruptcy protection in the first place. On the financial side, a good proportion comprises businesses that are either highly leveraged or that once changed hands in leveraged or management buyouts, e.g., Fruit of the Loom, DecisionOne, Jitney Jungle, and Geneva Steel. Allan J. Ellinger, a founder of Marketing Management Group, a New York-based investment banking boutique that specializes in the apparel industry, which traditionally has had a high incidence of bankruptcies, believes that industry pressures will send more clothing makers into Chapter 11 and that many will wind up as acquisition targets. A major problem, according to Ellinger, is that manufacturers are selling to fewer retailers that are “enormous” and in a position to exert heavy demands on their suppliers. “What retailing has done to the manufacturing community is hold it hostage,” he says. “As retailers have put more pressures on manufacturing, profit margins are down,” he continued. “They can’t reduce overhead fast enough and there are also pressures on net worth. They will be bought because they have good core businesses, but they just haven’t been able to manage them. In the bankruptcy proceeding, you can separate the business from a less than adequate balance sheet.” Bankruptcy attorney Walker notes that retailers also have a high incidence of bankruptcies, a major reason being that court protection allows them to escape bad leases or prune poorly performing stores. Questor’s Madden, a former investment banker, expects to see more acquisitions out of bankruptcy by both financial and strategic buyers because of the rapid growth of turnaround funds and greater recognition that rigor can produce great value. “We are willing to get in and roll up our sleeves and do the work that most buyout funds won’t do,” he says. “It takes a lot more work and time, and we have a greater commitment than most funds to the turnaround. Corporate acquirers now have the same view – that finding assets they can buy for 50 cents on the dollar will widen their spreads. It’s a pure case of risk-reward arbitrage.” Morris of Morris Anderson insists that taking a company out of Chapter 11 may be less risky than the orthodox one-off deal because the warts are in plain sight. “The truth about risks is that with appropriate advice and counsel, buying a troubled company can be less risky than buying a healthy company.” he says. “In the troubled business, everyone knows where the soft spots are. There are usually very few surprises in buying the underperforming or troubled business.” Walker agrees, saying that “due diligence is easier in Chapter 11 than anywhere else.” With value potential, the market for troubled companies has become quite sophisticated and even systematic. The three key elements in executing a successful deal, Morris says, are capital, which he described as relatively easy to obtain, a solid business plan for growing the business, which is doable, and good management, which is “usually the toughest part.” “All the buyer has to do is wrap them around a viable core business,” he asserts. Ellinger says the savviest acquirers in the apparel industry must be concerned with having the right strategy, the right people, and product compatibility in their deals. “If you work with people who understand the business and are pros, it can be painless,” he says. “If you understand where the risks are, these are not difficult deals.” Buyers also can find a warm welcome from bankruptcy judges, who sometimes take on the role of auctioneer. If an acquisition of a Chapter 11 company takes longer than a typical one-off transaction, it can be much shorter than the prolonged slugfest that frequently stretches out a reorganization process. Although the system varies from court to court, many have instituted “topping fees” to stimulate virtual auctions aimed at generating the highest amounts to pay off creditors. The fees encourage competition by assuring the first bidders on the scene that they will be compensated for their efforts should their offers be beaten by later arrivals. “The topping fees are designed to attract a stalking horse who gets the process started,” Walker states. “They are given a fee to protect them for their expenses if they are not the successful bidder. Otherwise, you can have a hard time getting people to step up.” Acquirers, investors, and others also have become defter in using prepackaged bankruptcies. All parties including creditors work out a reorganization and repayment plan before the Chapter 11 filing is submitted. With everyone on the same page, the process can be shortened and the bad blood prevented. If acquisition is the end game, the buyer of the distressed company can get the assets it wants without troublesome baggage. Still, the experts warn, buying out of bankruptcy is not for the faint-hearted or the unskilled. It can be a gut-wrenching proposition that many corporate acquirers believe isn’t worth the effort, regardless of the hidden gem they might pry loose. Even under the most inviting circumstances, there are tough-minded creditors committees to deal with. They are often composed of powerful financial institutions and trade suppliers represented by top-line attorneys who are out to recover the most they can for their clients. A lot of potential buyers, especially on the corporate side, also worry about image because of the way some deals are worked out. In many cases, the proceeds from the acquisition, although satisfying creditors, don’t leave anything for the shareholders or bondholders of the target. That is a projected outcome in the McDonald’s acquisition of Boston Chicken and the Value City purchase of Filene’s Basement, among other transactions. Many corporations would not like to be involved in those situations. In fact, even many who don’t shy away from acquiring out of bankruptcy say there is less hassle in shooting for the distressed company that has managed to avert a Chapter 11 filing. “These are companies that usually fall under the radar of most acquirers,” says Ellinger. Elliott Braverman, a tax and transaction attorney at the Philadelphia firm of Spector, Gadon & Rosen who has had wide experience in handling sales of troubled businesses, says he advises clients to think twice about buying a company in Chapter 11. “We tell clients that they must have some special reason to do the deal,” he says. No matter how smooth the path seems to be, Braverman says, there is always the formidable presence of creditors and judges that many business people are not equipped to handle. “My experience has been that there has always been a certain market for these kinds of companies,” he asserts. “The perception is that you can buy them cheap. But you are typically not dealing with an entrepreneur who overvalues but rather with trustees and courts and creditors that are interested in getting their own money out. It’s perceived to be a bargain, but there’s a lot of effort involved.” Nevertheless, Braverman points out that value can be produced by resurrecting the troubled business and says that there should be a continued brisk market for distressed operations that haven’t reached the bankruptcy courts. “The well-heeled buyer can fix them up,” he comments. “Sometimes the problems are seasonal or temporary. One man’s disaster is another man’s opportunity.” Major Acquisitions of Companies in Bankruptcy – 1999Acquirer Target Arch Communications Group Inc. MobileMedia Corp. RJR Nabisco Group Inc. Favorite Brands International Waccamaw Corp. HomePlace Stores Inc. MCI WorldCom Inc. Wireless One Inc. IBP Inc. Thorn Apple Valley Inc. Wellspring Capital Management LLC* Paragon Trade Brands Inc. ARNOS Corp.* Oil and gas assets of National Energy Group WF Cinema Holdings LP Mann Theatres unit of WestStar Holdings Inc. BJ Services Co. Fracmaster Ltd. Baxter International Inc. Pumps and devices business of Sabratek Corp. Cont’d Business Price ($mil) Cellular telephone service $668.7 Candy 475.0 Home furnishing stores 433.5 Wireless access services 131.7 Meat products 117.5 Diapers 115.0 Oil and gas 96.3 Movie theaters 91.0 Oil and gas well services 58.4 Medical pumps, surgical devices 48.0 *Financial buyer Source: Thomson Financial Securities Data<\TBL>