The retail sector continues to suffer from the changes to consumer spending habits and increased operating costs. With increasing regularity we hear of another retail company looking to restructure. It seems fairly predictable that retail will remain challenging.
By example, Debenhams and the tensions between Sports Direct (as the owner of 29.7% of the shares) and the management team have occupied many reports in the national press but, as of the end of March 2019, it had secured the requisite support from the holders of senior notes due for repayment in 2021 to enable £200m of refinancing on terms. This refinancing, in part, enabled the management to progress with other restructuring options including (i) a bid for a takeover (offered to Mike Ashley) by 08 April 2019 with conditions (ii) funding or underwriting the issue of new shares (iii) a debt for equity swap (iv) a pre-pack administration and possibly (v) a company voluntary arrangement (CVA).
Many of these options overlap, but the clear objective was the survival of of Debenhams. Offers for a take-over were made – and rejected – and Debenhams has since gone into administration. Given the current state of the market, it is still worthwhile examining the effects of debt for equity swaps, “pre-pack sales” and CVAs?
Debt for equity
The practice of “swapping” debt for an equity stake is a long established one. The advantages to the company of such an option is to remove the cash flow pressure caused (or exacerbated) by the need to meet prescribed repayments of principal and interest on debt. The taking of equity comes with it an understanding the returns will be longer term. Frequently the terms of the swap are intended to make the lenders taking equity preferential to the other equity holders both in terms of dividend and voting rights. This is required to ensure that, in return for the conversion and removal of cash flow pressure, the lender has the necessary powers to control operations and the right to receive dividends at par, but more likely in priority, to other shareholders. Clearly, the effect of the swap is to restructure the balance sheet to present a better financial picture of the company to the outside world.
Whilst taking debt out of a company, with the resulting cash flow relief, is a good thing, there are other factors to consider. There will some loss of control by the management of the company in favour of the holders of equity. There will be additional requirements limiting the ability of the company to raise further debt and make decisions about the future direction of the company without agreement from the investors. This can put the directors in a difficult position when trading the company. The directors must continue to discharge their duties but in circumstances when they may not have the necessary powers to do so.
A “pre-pack” sale is one which occurs immediately upon the appointment of administrators of a company and where all the work towards completion of the transaction is undertaken in advance. It is a sale by the company and its office-holders. The latter act as agents of the company. The marketing and the determination of the price are all done by the company and the proposed administrators in advance of any formal insolvency as the latter will need to demonstrate a sale of the business and assets upon appointment is at value.
In determining value the proposed office-holders will have regard to the outcome for creditors including, but not limited to, secured and preferential creditors. However, the focus on returns to creditors will depend on the “purpose” of the administration. This is the statutory purpose of the proposed administration. If the “purpose” is to achieve a better realisation for secured or preferential creditors then the price determination will be based on achieving the best for those classes of creditors given that there will be unlikely to be any distributions to be made to unsecured creditors (beyond the ring-fenced pot called the “Prescribed Part”) in any event.
The main advantage of a “pre-pack” is to achieve a sale of assets as a going concern and the continuation of the business. This, in turn, preserves jobs. However, whilst the liabilities of the company are left behind, the rights of employees transfer to the buyer. Often these employee liabilities are significant and the buyer needs to prepare to take these on. The disadvantages of this process is that it is possible that commercial agreements terminate on the administration of the company and the buyer has to re-negotiate terms to occupy leasehold premises.
Company voluntary arrangements (CVA)
The use of CVAs in the retail sector has become common. Predominately they have been used at landlords’ expense due to the multi-site operations of a retail operator. They are essentially a formal agreement between a company and its creditors which produces a better return than an insolvent liquidation would produce in respect of liabilities at the date of the CVA. CVA proposals in the retail space do go further, they allow a company to propose a reduction in future payments of rent and in some case the complete vacation of premises as part of the proposals. Most of the proposals made have been approved by the requisite 75% of creditors as the lesser of two evils: some rent and occupation versus empty units.
The advantages of a CVA for the company are obvious. The term of the CVA is for between 3 and 5 years and permits the company, if approved, to exit from leases or reduce the lease payments to allow the company to restructure based on better cash flow. However, a significant number of CVAs fail. The amounts due to be paid into a CVA are funded from continued trading. If the restructuring is unsuccessful and the targeted revenues are not met then the CVA will fail and the company will ultimately end up in administration or liquidation.
The retail sector is under pressure. The mere fact of the number of established brands preparing to restructure, entering into a CVA with creditors or entering administration demonstrates the extent of the issue. The management teams are addressing the trading issues, taking legal and insolvency practitioner advice and drawing up plans to restructure but the success of the plans are frequently in the hands of lenders and landlord groups who in turn have a lot to lose. Whether a retail operator with the large levels of debt and trading liabilities can, realistically, really ever clear the hurdles and restructure with a return to profit will depend upon the support the sector receives from consumers and the Government as well as the plans to change the way retail operates to meet the expectations of its customers. It is the quality of the underlying business and the quality and commitment of the management that determines the success of all restructuring options available and adopted by the company.