by Karen H. Wruck
Editor’s Note: Dr. Wruck’s presentation at the
Advanced Education Workshop was based on a June 2001 paper she co-authored with
Harry DeAngelo and Linda DeAngelo of the University of Southern California.
This is an excerpt from her presentation.
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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.
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
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
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
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
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
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
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
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
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
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
tures to have debt with
meaningful covenants because cash-flow constraints are not going to be
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.