What Does It Take to Reorganize a Retailer

Reorganizing under chapter 11 is a complicated feat at best. When the debtor is a
retailer, the challenge is even greater. The vast majority of chapter 11 plans
involving retailers are plans of liquidation following the sale of substantially all of
the retailer's assets. Indeed, in many cases chapter 11 filings by retailers were
not undertaken with the intent of reorganizing an ongoing business, but rather to
create a platform to sell the debtor's assets at their highest and best value. As
we have pointed out in prior columns, chapter 11 continues to provide the optimal
platform for extracting value for both the tangible and intangible assets of retailers.

</p><p>Assuming that the goal of a retailer is not an orderly liquidation of its assets but
instead is the restructuring of its business, what does it take? Here are some
things you may want to consider:

</p><p>1. <i>Debt.</i> Can the retailer incur additional debt to fund its restructuring and
exit? The first place you need to look is the liability side of the balance sheet.
The strong likelihood is that the retailer is financed in two ways: first, through
unsecured credit from its trade vendors, and second, through a mix of secured term
debt and asset-based credit facilities. Although there are a number of older large
retail companies that continue to enjoy access to unsecured credit from institutional
lenders and the public markets, there is a significant trend toward securitizing these
facilities and shifting to asset-based lending arrangements. This shift, combined with
the consolidation and specialization dynamics in the debt market, creates several new
variables to the debt structure. Different in name (Tranche A, Tranche B,
Convertible Preferred, Trade Liens, etc.), they all do the same thing: they
consume control of the retailer's tangible assets. Moreover, with the advent of new
Article 9's "all-assets" security interest and certainly in the context of DIP
loans, it is likely the case that the retailer's intangible assets will be encumbered
as well.

</p><p>Unless the retailer has had the foresight to commence its chapter 11 case well before
it has reached the point of encumbering all of its tangible and intangible assets,
it will be challenged to incorporate debt into advantages that can be used to develop
its reorganization plan. Debt is only available as a tool when there are unencumbered
assets against which lenders are prepared to lend.

</p><blockquote><blockquote>
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<big><center><i>
The best opportunity is likely to result from a
strategic partnership or from acquiring the
retailer by a strategic buyer.
</i></center></big>
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</blockquote></blockquote>

<p>The amount a lender is prepared to lend to a retailer in return for a lien against
the retailer's assets is called "availability." Whether or not there is quantifiable
availability will determine whether debt financing will support a retailer's chapter 11
restructuring. The lower the availability, the fewer options the retailer has in
managing ongoing performance and reorganization strategies. Credit managers and the
credit-monitoring services they rely on have become increasingly more sophisticated in
terms of making real-time assessments of a retailer's ability to incur additional debt.
As availability decreases, the retailer will find that its access to unsecured trade
vendor support decreases as well. This two-sided squeeze ultimately dooms the
reorganization prospects for many retailers.

</p><p>2. <i>Equity.</i> It will almost always be the case that equity positions must be
restructured for a retailer to reorganize under chapter 11. The very nature of
balance sheet and income statement performance require it. Public markets and income
generation/ cash-flow valuation dynamics challenge the realization of acceptable returns
on invested capital. This makes additional equity investment less attractive. By its
nature, creating a retailer's balance sheet is a capital-intensive exercise. Today's
retailers are increasingly required to make significant long-term investments into
infrastructure. Information/logistics technology, human resources and physical plant
investments are the capital needs requirements necessary to achieve a successful turnaround
and long-term growth and survival. The costs associated with such investments are
typically large and require extended timeframes to realize payback. Yet they are an
absolute requirement to compete and maximize ongoing profitability. An entity willing
to make an equity investment into a retailer today requires a strong stomach and a
lot of patience. While the typical ROI <i>pro forma</i> must measure returns over several
years, the dynamics of retailing today ensure that operating assumptions will change
over the course of several months.

</p><p>A retailer's performance is driven by efficiency, liquidity and concept. A
retailer's short-term results too often dictate strategy. This is especially true in
a restructuring where short-term results may dictate the nature of the long-term
player's assumptions. Any realistic equity investor must evaluate the delta difference
between the retailer's infrastructure requirements and the state of that infrastructure
at the time the proposed investment is to be made. When that delta is small, it
becomes more likely that a realistic opportunity exists for reorganization supported by
new equity. Unfortunately, in most cases, struggling retailers are forced to forego
capital investments in favor of shorter term fixes. The equity market demands immediate
results. In an effort to deliver those immediate results, retailers must often
sacrifice their long-term viability. The cost of remedying this situation comes in the
form of an even more elongated and increased investment horizon with a concomitant
negative impact on ROI and a reduced prospect that equity will be available to support
the retailer's reorganization.

</p><p>3. <i>Strategy.</i> As the foregoing discussion highlights, the driving issue for
struggling retailers facing the prospect of a bankruptcy court-supervised restructuring
is how short-term decisions affect long-term outcomes. The ever-widening gap between
good and bad retailers continues to produce competitive and marketplace forces that make
a successful reorganization a daunting task. The market place is vicious, ever-changing
and competitive. The time frames for correction are long and uncertain. Chapter 11
allows the retailer to close unprofitable stores and exit difficult markets. However,
fixes of this nature only staunch the bleeding. In and of themselves they rarely
address the fundamental requirements for long-term survival and prosperity. Strategic
initiatives may buy time. Alone, they will not buy ultimate success.

</p><p>Is there an answer to our question? It's a matter of resources. It is
reasonable to expect that for any troubled retailer, correction to liquidity issues,
efficiency and concept are necessary, with each just matters of degree. In evaluating
a retailer's prospects for reorganization, consideration must be given to how the
retailer gains access to the resources necessary to allow it to effectuate the
turnaround it desires. In this column, we have discussed turnarounds predicated on
increased debt, increased capital investment and improvement to ongoing performance. Each
of these potential solutions poses substantial challenges, and their pursuit substantial
risks. They are all long-shot bets that at the end of the day may only make sense
for out-of-the-money constituents to play.

</p><p>Where then can you find the resources necessary to reorganize a retailer? The best
opportunity is likely to result from a strategic partnership or from acquiring the
retailer by a strategic buyer. Although a strategic alliance or acquisition does not
ultimately result in a classic reorganization, it provides the best opportunity for the
preservation of value and long-term survival. The troubled retailer usually brings to
the table a melting pot of the good, the okay and the ugly. The addition of the
strategic partner or buyer's new resources further leverages the good, perhaps makes the
okay better, and depending on how the entities are joined, may absorb the negatives
of the ugly so that they do not become the predominate dictator of short-term
strategies and long-term results.