What we can learn from Edcon fortunes
BY BRIAN KANTOR for BDLIVE
BAIN, a private equity fund, has thrown in the towel on its involvement with Edcon and its leading retail brands including Edgars. When it took over Edcon in 2007, Bain immediately converted the equity stake it had acquired from the Edcon shareholders for about R25bn into additional Edcon debt of some R24bn. It has now reversed this transaction, converting the outstanding debt of Edcon back into equity.
The 2008 balance sheet reported total Edcon assets of R38.1bn, up from only R9.5bn the year before. Much of these extra assets were created by writing up the more expensive intangible assets including goodwill, that Bain had paid for and raised Edcon debt against.
The cash flow statement for 2008 reports “investments to expand operations: R24.4bn”. This was not so. The cash raised was used to reconstruct the balance sheet, not to expand operations.
Moreover, it failed to persuade the South African Revenue Service (SARS) that the extra borrowing was undertaken to produce extra income. Edcon continued to have to use cash from operations to pay significant amounts of tax as well as a large and growing euro interest bill. Despite large accounting losses, it delivered cash to SARS at the rate of more than R100m a year.
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 presumably 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.
With the agreement of its creditors with all the shares in Edcon, and with new debt raised of about R6bn, Edcon can avoid the expensive horrors of business rescue and continue to operate normally, much to the relief of its managers, workers and landlords. Given that Edcon continues to realise significant trading profit, it makes every sense for it to stay in business in the hope of delivering value for its new shareholders while other stakeholders are protected.
The case for private over public equity is not based on a highly leveraged, risky financial structure that promises high returns as compensation for high default risks. While the conversion from public to private may only be affected with significant dollops of debt, the case for private is that its few shareholders, with much to gain or lose, will be able to contribute meaningfully to the success of the venture. This is unlike inactive public shareholders with highly diversified portfolios, who can easily walk away from an underperforming investment.
It is thus no accident that the number of companies listed on all the US stock exchanges has declined drastically over recent years — by between 40% and 60% in the past 25 years, according to different estimates. The competitive threat to public companies from private equity, funded with public money, should therefore be encouraged and not discouraged (including by SARS) in the interest of better returns on capital and a stronger economy.
For their errors of commission (too much of the wrong kind of debt) and omission (managing its assets poorly) Bain and the Edcon managers were unable to improve its operating performance enough to meet the obligations to debt-holders — despite their well-aligned interests. The debt-holders and Bain, appropriately so, have had to suffer for their mistakes.
How much the Edcon equity is now worth to compensate the debt-holders will be determined when their Edcon shares are relisted on the JSE. The sooner the new shareholders get to know their value and how well the company is performing under new management, the better.
• Kantor is the chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity