The Edcon story – was it a failure of capital structure or of management? Or a bit of both?
Bain and Company, a private equity fund, has thrown in the towel on its involvement with Edcon, a private company that it has owned and controlled since 2007. When it took over, it immediately converted the equity stake it had acquired from Edcon shareholders for some R25bn (with almost no long term debt on the Edcon balance sheet) into additional Edcon debt of some R24bn, with some additional finance of about R5bn provided as loans from its controlling shareholders. It has now reversed this transaction, converting the considerable outstanding debts of Edcon back into equity. Edcon is the owner and manager of Edgars, a leading clothing retailer as well of other retail brands, including CNA and Boardmans.
The 2008 balance sheet reported total Edcon assets of R38.1bn, up from R9.5bn the year before. Much of the these extra assets were created by writing up the intangible assets, including goodwill, that Bain had paid up for and raised Edcon debt against. The cash flow statement for 2008 reports “investments to expand operations: R24.4bn”. This was a euphemism – the cash was patently used to reconstruct the balance sheet, not to expand operations.
More important for the new shareholders than the description in its financial reports, it failed to persuade the SA Revenue Service (SARS) that the extra borrowing was undertaken to produce extra income. As a result, Edcon continued to have to use some of the cash it was generating from operations to pay significant amounts of tax as well as the interest it was committed to paying. In the early period, the 47 weeks to 29 March 2008, it paid cash taxes of R246m. And despite the fact that large ongoing accounting losses that were incurred as interest expenses greatly exceeded trading profits, it continued to deliver cash to SARS at the rate of over R100m per annum. More recently, according to the cash flow statement in the 13 weeks to 26 December 2015, cash taxes paid amounted to R32m.
This appears as a large mistake when Edcon was originally reconstructed. Presumably, had Bain registered a new company to buy out the Edcon assets from its shareholders and this company had then funded the purchase with debt, the interest expense would have been allowed as incurred in the production of income. And the consequent losses could have been carried forward to offset future income and to raise the current value of the company.
Much of this debt was to mature in 2014-15 (a commitment that Edcon was unable to fulfil) as was long apparent and well-reflected in the much diminished market value of its debt that traded on global markets. It will be appreciated that the Edcon financial losses have mostly been incurred by its creditors, not by Bain and Company. The statement of Edcon’s financial position in December 2015 reports a shareholders’ loan of R828m, well down from the more than R5bn recorded in 2008. Clearly Bain and its co-shareholders have walked away with nothing to show for their efforts. The company is by all accounts now worth less than was paid for it in 2008.
In the charts below we convert the 71% of Edcon euro debt it incurred into rands at current exchange rates. In January 2008 a euro cost R11.12. As may be seen, the rand value of this euro debt is now significantly higher than it was in early 2008. But the rand value of this original debt had actually fallen significantly by 2010, providing an opportunity to restructure the debt with profit that apparently was ignored.
We have rebased this index and the retailers’ dividend per share to January 2008. We have also converted these additional rand values into euros at current values. As may be seen, the share market backdrop for clothing retailers and their ilk on the JSE was encouraging, but more so in rands than in euros (until very recently) with its combination of weaker retail share prices and a weaker rand. It seems clear that had Edcon operated in line with its competition, it could have added value for its shareholders and its debt, particularly had it been converted to rand debt (which would have been manageable).
Bain and its funders clearly failed to realise the prospective gains they envisaged when they geared up the Edcon balance sheet. The potential rewards to the owners of the much reduced equity capital were potentially very large had the company proved able to service its debts. On returning to public company status, the possibly R5bn of equity finance provided might have doubled in value had the market value of the company gained an additional R10bn of value over the 10 years.
To put it another way: had Edcon performed as well as the average general retailer did on the JSE over the period, these gains would have been realised. But the average JSE-listed clothing retailer was not encumbered by nearly as much debt, particularly the 71% of its debt denominated in euros. This appears as the major original strategic error made by Bain to which it never made the adjustment. Combining rand revenues that Edcon would generate, with hard currency debt, represents a highly risky strategy. Perhaps the SA debt market would not have been willing to subscribe the large amount of the extra debt raised. But there was surely always the opportunity to fully hedge the foreign currency risk. But this would have meant paying interest at a South African rather than a euro or dollar rate, a cost that, had it been incurred, may well have (correctly perhaps with hindsight) undermined the investment case for a highly leveraged play on the SA retail market.
The Edcon experience has unfortunately not been able to add to the case for private equity over the public equity alternative in SA, that is to say, to use public money to take a (large) listed company private. The case for private equity is not based on its superior financial structure of more debt and less equity, though clearly the leverage adds greatly to the potential returns for equity holders (assuming all turns out well for the company). Moreover, the conversion of a public company to a private one, through private equity funds, or more or less the same thing, through a management buyout, may not be possible without significant reliance on debt finance. The case for private equity is that the few shareholders with much to gain and lose have every incentive to closely and better manage their stake in the company. They will be very active shareholders with highly concentrated investments, unlike those of the average listed company with wider stakeholders, as opposed to shareholder interests, to serve. The large publicly funded private company represents therefore a very helpful competitive threat to the public company, from which shareholders (including pension funds) the economy and its growth prospects can benefit.
It is thus no accident that the number of companies listed on all the US stock exchanges has declined dramatically over recent years, by between 40% and 60% over the past 25 years according to different estimates, as pension funds and endowments have increased their allocations to alternative investments and especially to private equity funds. Private companies may well, on a balance of full considerations, serve their owners better than public companies.
The competitive threat therefore should be encouraged and not discouraged (including by SARS). The objective of tax policies should be much wider than merely protecting the tax base. Private equity, by adding to the growth potential of an economy and especially adding to the willingness of the system to bear additional risks for the prospect of additional returns, deserves no less or more than equal tax treatment.
For its errors of commission and omission, Bain and the managers it chose for Edcon, were unable to improve its operating performance. How much this equity is now worth is a matter of conjecture that can only be resolved when, as is the intention, these Edcon shares are re-listed on the JSE. The sooner the current Edcon shareholders get to know what their shares are worth, surely the better and the sooner the shares can be listed and so could pass into the hands of perhaps more active investors, the better the company can be expected to perform. 27 September 2016