Asset liquidity, debt covenants, and managerial di

AssetLiquidity,DebtCovenants,andManagerialDiscretioninFinancialDistress:TheCollapseofL.A.GearbyHarryDeAngelo*LindaDeAngelo*KarenH.Wruck**June2001AbstractAhotgrowthstockinthe1980s,L.A.Gear’sequityfellfrom$1billioninmarketvaluein1989tozeroin1998.Foroversixyearsasrevenuesdeclinedprecipitously,managementtriedaseriesofradicalstrategyshiftswhilesubsidizingthefirm’slargelossesthroughworking-capitalliquidations.TheL.A.Gearcaseillustratesthatassetliquidity(broadlyconstrued,notlimitedtoexcesscash)cangivemanagerssubstantialoperatingdiscretionduringfinancialdistress.Italsoshows(i)thatdebtcovenantscanbestrongerdisciplinarymechanismsthanrequirementstomeetcashinterestpayments,(ii)whydebtcontractstypicallyconstrainearningsinsteadofcashflow,(iii)whycashbalancesarenotequivalenttonegativedebt,and(iv)whydebtmaturitymatters.Wefindthatmanyfirmshavehighlyliquidassetstructures,thustheirmanagershavethe[e-mail]@[e-mail]*UniversityofSouthernCaliforniaand**TheOhioStateUniversityWearegratefultoJonKarpoff,RenéStulz,EricWruck,ananonymousrefereeandespeciallyCliffordSmith(areferee)forusefulcomments,toIdoDotanforresearchassistance,andtotheUniversityofSouthernCalifornia(CharlesE.Cook/CommunityBankandKennethKingStonierChairs)andtheCharlesA.DiceCenterforResearchinFinancialEconomicsattheOhioStateUniversityforfinancialsupport.AssetLiquidity,DebtCovenants,andManagerialDiscretioninFinancialDistress:TheCollapseofL.A.Gear1.IntroductionIn1989,L.A.Gearwasthetop-performingcommonstockontheNYSE,afterhavingregisteredthethirdlargestpercentgainamongNASDAQstocksin1988.Thefirmbecamefamousinthe1980sforitstrendywomen’scasualfootwearandracyadsfeaturingscantilycladCaliforniablondes.L.A.Gear’sexceptionalstockpriceperformancebeganwiththefirm’s1986IPO,whichwasoneofonlysevennon-pennystockofferingsinthedecadethatmorethandoubledonthefirsttradingday,outpacingevenGenentech’s104%initialdayreturn(Ritter(2000)).In1988,itwasnamedCompanyoftheYearbyFootwearNewsMagazineandalsorankednumberthreeonBusinessWeek’slistofthe100BestSmallCorporations.Inthelate1980sL.A.Gearproducedanumberofwildlysuccessfulfashionhitswithteenagegirlsandyoungwomen,includingsuchitemsashigh-toppinksequinedsneakersandsilverandgoldlaméworkoutshoes,growingitsrevenuesfrom$11millionin1985to$820millionin1990.L.A.Gear’sinitialsuccesswasshort-lived,asthefashionexcessesofthe1980swerefollowedintheearly1990sbymoreausterelifestyletrendsthatthefirmfailedtoanticipate.Thisblunderengenderedliquidityproblemsduetorestrictivecovenantsinthefirm’sbankcreditline.Managementrespondedbysellingexcessinventoriestodeepdiscountoutlets,therebydamagingthebrandwithconsumersandalienatingfullpriceretailers.By1991,quarterlyloss-inducedcovenantviolationsledmanagementtoseekexternalfinancing,whichitobtainedbysellingoperatingcontroltoTrefoilCapitalInvestorsL.P.TrefoilimmediatelybroughtinanewpresidentandeasedoutRobertGreenberg,thefounder/CEOwhohadmastermindedL.A.Gear’sglitzydesigns.Overthenextsixyears,Trefoiloversawthreedifferentoperatingmanagementswhotriedaseriesofradicalstrategicshifts,allofwhichfailedtoresuscitateL.A.Gear.Bymid-1998,thecompany’sstock,valuedatnearly$1billionatits1989peak,wasliterallyworthzeroinbankruptcyproceedings.Thecompany,onceknownforitsmeteoricrise,becamemorefamousforitsdramaticdecline,describedbytheNewYorkTimes(“TryingaNewShoeonforSize,”July18,2000,C1)asoneofthe“industry’smostspectacularcollapses.”2L.A.Gear’scollapseisremarkablebecausethefirmbledenormousamountsofcashforoversixyearsbeforefinallyfailingtomakeaninterestpayment,allthewhilesufferinglargelossesanddramaticallydecliningrevenues.AlthoughL.A.Gearbegan1991,itsfirstyearunderTrefoil,withjust$3.3millionincash,itssubsequentcash“burnrate”wassome$36millionperyearforatotalcashearningsdeficitof$215millionover1991-1996.Thefirmraisedonly$35millioninnetnewfinancing,funding$180millionofcashlossesviainternalsources($180millionis80%ofL.A.Gear’sequityvalueatyear-end1990).During1991-1996,TrefoiltriedanumberofnewdirectionsatL.A.Gear,includinganemphasisonmen’sperformanceathleticshoesandashiftinitsdistributionchannelsawayfromupscaledepartmentstorestomassmarketerssuchasWal-Mart.L.A.Gear’srevenuesfellfrom$820millionin1990to$196millionin1996.Itsdomesticmarketsharefellfrom12%in1990,whenitrankedthirdbehindNikeandReebok,to2%in1996,whenitrankedninth.Inlate1997,Trefoilsolditsequitystake,forwhichithadpaid$100millionin1991,for$228,000.Onemonthlater,L.A.Gearfailedforthefirsttimetopayinterestonitsdebt,andinJanuary1998thefirmfiledforChapter11bankruptcyprotection.L.A.Gear’shighlyliquidassetstructureisthekeyfactorthatenabledthefirmtomeetitsdebtobligationsandkeepoperatingforsixyearsdespiteitsprodigiouscash“burnrate.”Thefirmheldonlyamodestamountofcashwhenitsfinancialtroublesbegan,andsoitsabilitytosustainprolongedlossesisnotattributabletolargecashbalances(ashypothesizedforfirmsingeneralbyOpler,Pinkowitz,Stulz,andWilliamson(1999,p.44)).Rather,TrefoilsubsidizedL.A.Gear’songoinglossesbyliquidati