The Turnaround Management Association Headquarters published an article entitled "The Rise and Fall of L.A. Gear" by Karen H. Wruck on 1Nov 2001:In some sense, L.A. Gear was a quintessential 1980’s company. The notion was to capture the L.A. lifestyle. It sold pretty glitzy stuff-sequined and lamé workout shoes, Crayola-colored hightops and so forth. Although it’s still around in a very small version of its former self, L.A. Gear, with its meteoric rise and its long slide into bankruptcy, presents an interesting case study in asset liquidity, debt covenants and managerial discretion.
This is a company that went public in 1986. Its stock doubled on the first day of trading. In 1988, it got enormous public kudos, not only from trade magazines such as Footwear News but from mainstream media as well-it was number three on Business Week’s list of 100 best small businesses. It had the third-largest percentage gain on Nasdaq. In 1989, the equity reached a market capitalization of $1 billion. It was the largest appreciation that year on the New York Stock Exchange. That’s the rise of L.A. Gear.
And this is the fall. In 1990 and 1991, fashion moved from glitter to grunge. The problem was, L.A. Gear didn’t make much of a transition in terms of its style and, from 1990 to 1996, revenue declined from $820 million to $196 million. In 1998, by the time the company filed bankruptcy, the common stock was literally worth zero.
Why is the rise and fall of L.A. Gear so interesting now? For one thing, we’ve been seeing an awful lot of this rise and fall business lately in the market. Studying this case can give us insights into the kinds of failures we can expect in the high-tech and dot-com sectors over the next two or three years.
L.A. Gear designed products, outsourced its manufacturing and distributed products, but it didn’t have plants, and it didn’t have a lot of employees, even at its peak. There were not a lot of physical assets. What assets it did have were highly liquid—most of the assets were inventory, which played a critical role as its demise unfolded.
By the time the decline started, professional turnaround management was involved. They had a top management team and a board of directors, both of which had substantial equity stakes in the firm and considerable turnaround experience.
But one of the most interesting things about L.A. Gear is that it rises quickly and falls very slowly. How can this company continue for so long without solving its management strategy problems; without substantial external financing, which allowed it to escape the discipline of external markets; and without creditor or investor intervention?
Company History L.A. Gear was founded in 1979 by Robert Greenberg. The former hairdresser and wig salesman started out by selling shoelaces in Venice Beach, Calif. He founded a trendy women’s clothing store and his fortunes started to take off. In 1983, he hired Sandy Saemann, who basically ran L.A. Gear’s advertising in-house. Their strategy was to sell predominantly through upscale department stores, such as Nordstrom.
They did something that, at least at the outset, was quite clever. They had what they called an at-once retail ordering system, which meant that retailers could order in small quantities. If they ran out, they could order again. The industry standard, at least for companies such as Nike and Reebok, was something called a futures ordering system, which basically meant that they showed you the styles for the season, you decided how many you wanted and you stocked them. If you ran out, you ran out.
So, L.A. Gear was giving retailers more flexibility in the hopes of being competitive. Perhaps behind the strategy was the notion that by not requiring retailers to order large quantities, L.A. Gear was more likely to obtain future deals, once the stores tried out the merchandise and saw how well it sold.
People said at the time that Greenberg’s fashion sense combined with Saemann’s advertising and marketing skills were the keys to the rise of L.A. Gear. With the initial success in women’s shoes, Greenberg and Saemann started diversifying.
By diversifying, the company didn’t really move into another line of business; it expanded its offerings to move beyond women’s shoes and into men’s and children’s shoes. In 1986, women’s shoes were 82 percent of sales; by 1990, they were only 35 percent of sales, so they made some progress in men’s and children’s shoes. They also added apparel lines and sold their products internationally.
In 1990, L.A. Gear made a very big push to enter the market in men’s performance athletic shoes. In some sense, this is when the company’s troubles started. It launched a line of men’s sneakers endorsed by Kareem Abdul-Jabar. No one was at all interested. The company also wanted to sell men’s leisure shoes, black shoes, sponsored by Michael Jackson. No one was interested in that idea either.
Then, the company had a problem when a pair of its sneakers fell apart, literally, on national television. A college basketball player from Marquette University who was wearing L.A. Gear shoes ended up hitting the floor because his shoes fell apart. When you’re struggling to enter men’s performance shoe market, this is not a good thing.
The result of all of this, in part, was a large inventory buildup at the end of 1990 and early in 1991. L.A. Gear had a lot of shoes that weren’t selling very well. What were they going to do with them?
If you think about the company’s brand name and positioning and who the upscale retailers were that carried them, one option might have been just to take all of the sneakers and burn them. But they didn’t do that. Instead, they dumped them. So, for a little while, you could buy L.A. Gear products at Nordstrom, at the flea market or in a back alley. It did generate some cash. However, it damaged the brand name and the company’s relationship with retailers.
The Turnaround Firm
In January 1991, L.A. Gear had a quarterly loss that triggered a technical default on its bank debt, which was carried by Bank of America. In June 1991, they had another quarterly loss, which triggered its second technical default.
Very shortly after that, a new active investor entered in the guise of a company called Trefoil. This group had a stable of successful turnarounds. They made a $100 million investment in the firm in exchange for redeemable preferred stock. They got to pick the management team, and they also got to run the board of directors.
Immediately, the company made management and governance changes. Saemann resigned two weeks after Trefoil made its initial investment. Greenberg was gone within six months. After Greenberg left, Trefoil hired Mark Goldston, who had been a Reebok executive.
Trefoil ran L.A. Gear from 1991 to 1997. It ended up selling its $100 million stake for $228,000. Bad things can happen to good turnaround people.
In six years, Trefoil had essentially three different management teams. The company struggled to settle on what kind of a firm L.A. Gear was going to be. In 1991, Goldston emphasized men’s athletic shoes and tried to rid the company of the flea market image problem. The company also implemented a futures ordering system. In 1992 and 1993, the company changed and decided to forego the men’s athletic shoe market and focus on children’s shoes. It also turned to other stores to dispose of its other merchandise. The company had a big contract with Wal-Mart and increased its mass marketing emphasis there.
By 1993, things were still going forward, but Goldston was out and William Benford was in. He had been L.A. Gear’s CFO at the time that Goldston was president. During Benford’s year at the helm, the company basically went through a period of returning to its roots. It wanted to emphasize women’s and children’s shoes. The company closed all of its outlet stores. They were still doing a lot of mass marketing sales, but they were not meeting minimum volume requirements, and Wal-Mart cut them off.
Then, L.A. Gear attempted to acquire a company called Ryka, another women’s athletic shoe company. This is a very ardent women’s self-esteem, feminist kind of company. It was described as a cause-marketing firm, as opposed to L.A. Gear, which was a glitzy cheerleader-type firm, and there was some concern that this match was not made in heaven, even though they both sold shoes for women. That fell through.
Benford’s term was over and the company still was not doing well, so Bruce MacGregor, who has been senior vice president of marketing at L.A. Gear, was named to head the company. One of the things that he tried was to say, "Our brand name is so ruined, let’s just take it off a lot of our products and see if people will sell them under different names or no name at all." He also abandoned the company’s joint ventures and tried to sell internationally.
In terms of retail financial performance, sales during this period dropped from $820 million to $196 million, and gross profit margin dropped from 35 percent to 24 percent. The company’s net income dropped from $31.3 million to a loss of $51. 7 million.
Operating Cash Flow
The high-liquid-asset structure of L.A. Gear delayed the day of reckoning by six years. Basically, L.A. Gear’s working capital liquidation was the primary source of funds to cover its operating losses over a long period of time.
The company paid all of its bank debt after its initial default, so it basically was free of intensive bank monitoring.
The company did issue some public debt, which was covenant-free, with a 10-year maturity. So, if the company managed to last 10 years, those public bondholders would get back their principal payments. In the interim, however, all the company paid back was interest.
The company did obtain bank-backed guarantees that it used for shipments from suppliers. Up to the day the company filed Chapter 11, it was using letters of credit. One of the last versions of L.A. Gear’s credit agreements extracted a $750,000 upfront fee, and by the end, the company was paying a $50,000-a-month maintenance fee to support the letter of credit.
L.A. Gear’s highly liquid asset structure was really the source of this managerial discretion. The company had a lot of latitude to experiment without being required to undergo any kind of external monitoring or obtain validation for its different strategies and management teams.
They created and sustained those strong cash positions by doing what seemed practical—drawing down the company’s liquid assets. They started with very large inventory and receivable balances, and current assets declined from $338.4 million in 1991 to $96.7 million in 1996. They were about to fail, and they still had almost $100 million in current assets.
During the six years of protracted distress, you can look at the financials and see numbers like cash/interest as high as 59.1 times, current assets/interest as high as 162 times and working capital/interest as high as 118 times.
Between 1986 and 1990, L.A. Gear had had positive earnings in all years but negative net operating cash flow. All of that profit and then some—because they were borrowing from the bank at that point—was going to investment in working capital to support the firm’s growth. If you want to continue to grow like that, from $11 million in revenues to $821 million in revenues, you’re going to require the bank to lend you money.
Trefoil also had big negative cash earnings in the years it ran L.A. Gear. But once you took into account the net change in working capital, they had big positive operating cash flow. They didn’t need any kind of external financing.
Bank Constraints
There were some constraints on L.A. Gear during this period. Even though the company had retired all of its bank debt, it was still using bank letters of credit to support inventory purchases and to guarantee the producers in Asia that they would pay them for the shoes that they made. What happened was that those letters of credit had some covenants that would be renegotiated regularly. Each time, the bank reduced its exposure, but at the same time, L.A. Gear management retained substantial discretion.
Between 1991 and 1997, L.A. Gear had 14 versions of the credit agreement with Bank of America. In every one of them, the amount the firm could potentially borrow—which it never did—was reduced. Covenants were rewritten, and fees were extracted. Some of them came in the form of interest rates, but a lot of them came in the form of up-front fees.
By the end, you were seeing things like the bank saying, "We will give you another credit agreement to support your purchases, but we want $750,000 up front." And the management said, "Fine." What choice did they have? Without a line of credit, they weren’t going to be able to sell anything. No producer was going to float them at this point.
In the end, when it filed bankruptcy, L.A. Gear was paying $50,000 a month in fees. These were big numbers, but the bank was protecting itself by extracting cash over time out of the company. Essentially, the rest of the cash was used to fund operating losses and strategic experimentation.
Sometimes, a bank plays a role that benefits all of the claim holders of a company. You see a triggering of the default on bank debt, which puts the firm in technical default, and suddenly, everybody pays attention. You may have a productive negotiation for all groups. In the case of L.A. Gear, that wasn’t what was going on.
Restrictions
L.A. Gear did have covenants towards the end that restricted distribution to shareholders and that prevented the firm from selling physical assets, such as a warehouse, a desk, a computer. But there’s a gray area where, as a lender, you really don’t want to write covenants that restrict managers from doing what they ought to be expert at—you want to give them the discretion to run the business the best way they can.
What’s interesting about the strategic shift in L.A. Gear is it’s not as if they tried to exit the athletic shoe industry. They would have been prevented from doing that. All the shifts they made were things that looked reasonable within their core line of business.
Who knew what the right level of working capital was at L.A. Gear? It’s very hard to write a covenant that says, "We have X dollars in working capital." But you also know that in a decline, that’s where the cash is going to come from, and that’s an area that must be watched very closely.
From a banking perspective, L.A. Gear did exactly what it had to do. At the very end, this company was not going to get letters of credit from any other banking institution, period. Sure, the fees sound high, but if Bank of America pulled its line of credit, L.A. Gear didn’t have a business. And from the bank’s perspective, it was a pretty high-risk business.
General Implications
Asset liquidity, broadly construed and not limited to cash balances, is a very important determinant of managerial discretion in a firm. The more discretion the managers have, of course, the higher the pressure that is put on the board of directors to monitor and govern well. One of the things to think about in a firm with high liquid assets is how debt contracts are structured in terms of covenants and the maturity structure of debt.
With these kinds of firms, accounting-based or non-cash covenants can be more constraining than the requirement to make principal and interest payments. People tend to think about technical defaults as being kind of an early warning and a cash default as a really serious event. But this is a group of firms for which the reverse is true.
These firms are never going to cash default until they’ve depleted the value of the firm, but they may have technical defaults earlier. It’s very important in lending to firms with high liquid asset struc tures to have debt with meaningful covenants because cash-flow constraints are not going to be particularly binding.
It’s also important to remember that liquid assets are not equivalent to negative debt from a managerial discretion point of view. A lot of times when people look at a balance sheet of a firm, they’ll say, "Okay, it borrowed $10 million, it’s got $5 million in cash, so on net, it’s about $5 million in debt."
That’s not quite true because as a lender to that firm, you may not be able to stop the expenditure of that cash for the benefit of shareholders at your expense. You cannot rely on the liquid assets lying around acting as a cushion. They’re almost a way to undermine some of your issues. You have to worry about security for debt.
Finally, shorter-term debt restricts management’s ability to buy time because when the debt expires, the company has to go back to its lender and renegotiate the debt contract. If lenders observe deterioration in the performance of the firm, they can protect themselves and extract value for the added risks.
Trefoil was a professional, highly skilled turnaround firm. They truly believed all along that they were going to turn around this company and resurrect it. Even among the best managers, there’s a tendency to take these liquid assets and continue investing in the firm, thinking that, "I’ve been successful in the past. I’m going to continue to be successful in the future."
Liquid assets increase that temptation a lot. These were good people, but they were perhaps overly optimistic about turning this firm around.
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