1- Why is Marvel in financial distress? Bad luck? Bad strategy? Bad implementation? When possible, back your claims with numbers.
Several factors led to the financial distress of Marvel. The main problem due to which the company is facing bankruptcy is the issuance of excessive debt. Moreover, the company collateralized this debt against its shares. The debt taken by the company was secured by 77.3 million shares – almost 76% of the total number of outstanding shares. The details of these collateralized shares are provided in exhibit 6 of the case study. These debts were issued by separate holding companies of Marvel and carried high interest. As the company’s profitability declined, it became increasingly difficult to finance the debt. The root cause of the downfall of marvel, therefore, lies in the reasons behind the decline in profitability and issuance of high amount debt.
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The early moves of Ron Perelman, which focused of financial efficiency, were highly successful. Gaining confidence from his early success, Perelman proceeded with three strategic shifts that eventually led to the downfall of Marvel. First, he tried to increase revenue growth by increasing the prices of comic books at regular intervals. This was a big mistake since it ignored the underlying reason for the popularity of comic books. The comic books had gotten popular during the economic depression as it provided cheap entertainment. However, Perelman dissociated itself from its target audience by regularly raising the prices. Second, Perelman created numerous new comics in an attempt to increase the industry size and decrease his marginal costs through economies of scale. However, this strategy was implemented on the expense of the quality of the comics. The quality of the new as well as old comics further deteriorated as the company lost its focus. Consequently, the poorly written and expensive comics no longer appeared to be an attractive source of entertainment. Third, Perelman picked the wrong time to go on a spending spree of acquiring other businesses in order to build an empire. The company did not have the capacity to support such acquisitions and pushed it into a liquidity crisis as the profits tumbled.
Therefore, the decline in the profitability of the company was not because of a series of unfortunate events as implied by the CEO. The decline in profitability was a result of the bad strategic decisions taken by its acquirer Ron Perelman. The choices made by Perelman created a bomb, which exploded as soon as the company passed the tipping point. The problem was further accentuated by Perelman’s obsession to own 80% stake in the company. It is understood that the majority ownership provided potential tax benefits to Perelman. However, the move not in the best interest of Marvel as it put the company in a dangerous solvency position.
2- Why did Marvel file for Chapter 11 rather than restructure out-of-court?
The bondholders of the holding companies were not satisfied with the restructuring plan proposed by marvel. The bondholders felt that they were not getting a fair deal under the restructuring terms. Perelman’s restructuring bid was believed to be focused around his maintenance of majority stake in the company. For an out-of-court settlement, Perelman needed a unanimous support of all the stakeholders. However, it was clear that some of the stakeholders (predominantly bondholders of holding company debt) were not going to support the restructuring. Therefore, Marvel, under the leadership of Perelman, decided to file for bankruptcy. Under the terms of bankruptcy, Perelman no longer needed the unanimous support for all stakeholders. The required consensus was reduced to a majority support from all classes of stakeholders. The majority constituted 51% of the number of claimants in each class and two-thirds of the total amount held by claimants in each class. Effectively, two-thirds of the bondholders (measured by amount owed) now needed to approve Perelman’s restructuring plan (as opposed to all of them in an out-of-court settlement). Moreover, the judge could still rule in favor of Perelman if he felt that the non-conforming stakeholders’ interests were adequately met through the restructuring plan. Bankruptcy also improved the company’s liquidity position, as it was able to finance $100 million to pay its short-term obligations during the reorganization. Bankruptcy provided the company with a fresh start and protected it from creditors and future litigations.
3- What do different stakeholders of Marvel get under liquidation? What if the firm just continues to operate without restructuring?
According to the liquidation analysis presented in exhibit 7, Marvel could expect to generate about $436 million from liquidation of its assets net of bankruptcy costs. Marvel could also realize some additional proceeds by selling its minority stake in Toy Biz. This would generate total proceeds of about $560 million for Marvel. However, the company had an obligation to pay the debt of $192 million taken by its subsidiary Panini. This left the company with net proceeds of about $369 million for its other creditors. The secured creditors of the company had a priority claim over the liquidated company when compared to the unsecured bondholders. The secured debt of the company amounted to about $535 million. This meant that approximately 69% of the secured debt could be paid with the remaining amount of company’s assets. Therefore, the company’s shareholders and unsecured bondholder would get nothing under a liquidation of the company.
It was highly unlikely that the firm could survive by continuing to operate without restructuring. The company was in a clear risk of default. It had already violated its debt covenants and was not likely to meet its debt obligations in the wake of impending operating losses. The company was in no position to refinance its existing debt by issuing new debt since no lender would be willing to finance the company in its current state. A default of the current debt payments would have invited litigations, and the company would be forced to declare bankruptcy.
4- Evaluate the (new) restructuring plan. Assuming that the plan is approved, will it solve the problems that caused Marvel to be in financial distress? If yes, how? If not, why not?
In a bid to maintain control of the sinking company, Perelman proposed that his company would inject another $365 million in the company for 427 million new shares. The new shares were designed for Perelman to keep majority stake in the new company for tax benefits. The main contention, however, was the price paid for each share of the restructured company. Perelman was paying less than $1 for the shares when the market price of the company was over $2. In fact, when the plan was first proposed, the market price was over $4 before the announcement and dropped by more than $1 following the announcement. The bondholders termed Perelman’s restructuring an ‘unconscionable attempt to maintain control of the company’. Among other components of the plan, Marvel was going to acquire Toy Biz for its high cash flows that can be used to service the high debt payments of the company. The debt of the bondholders, which amount to 894.1 million before the collapse of Marvel, would be converted to 77.3 million equity shares in the restructured company – an equity share of 14.6%.
The bondholders would not get anything out of the company if it is liquidated. In this plan, they are getting a minority stake. However, this stake would only have value of the restructuring plan is able to get the company out of muddy waters. Bear Sterns, the consulting company hired to evaluate the bankruptcy position of Marvel, argues that the company is worth more as a going concern than under liquidation. Therefore, it is logical to assume that bondholder stand to gain more from a restructured company. However, Bear Sterns also concede that the restructured company will be in a dangerous position because of its high debt. Moreover, the consulting company is due to receive $1 million in compensation if the restructuring plan is approved. This is sufficient reason to doubt the objectivity of their statements. The acquisition of Toy Biz seems like a good move as part of the restructuring process. The company might have synergies with Marvel, as it has been closely associated with the company. Furthermore, Marvel is in desperate need of the financial stability that Toy Biz can provide. However, the grand plans for opening of movie studios and theme restaurants produced the same vibe of opening a diverse line of business that had contributed to the downfall of Marvel. It is believed that the company would be better off if it concentrates on its core business after the restructuring – that is production and sale of quality comics at a reasonable price.
5- What is your assessment of the pro forma financial projections and liquidation assumptions? What are the different parties incentives to bias the valuation and in what direction?
The financial projections of the company can be put into perspective once we have an estimate of the risk carried by the equity holders of the restructured company. The risk of the equity holders can be measured through the required return of equity holders. The asset beta of the company is 0.65. The beta can be used to find levered equity bet of the company through the Hamada’s equation. To apply the Hamada’s equation, we need the debt to equity ratio as well as the applicable tax rate. The tax rate has been assumed to be 35% - the corporate tax rate in the US. The market value of debt and equity after the restructuring are hard to predict. The book value of equity is 88% at the start and is projected to drop to about 80% in five years. Using this information, the long-term debt to equity ratio can be assumed to be 85%. Although this is an unusually high target ratio, it is arguably the best estimate of the value under the circumstances. Using these parameters, the levered equity beta of the restructured company can be estimated to be around 3. This beta can be subsequently used in the CAPM equation to calculate the required return on equity. For CAPM, we need two additional parameters. The risk-free rate and the equity market risk premium. The risk-free rate is taken to be equal to the five-year Treasury bill rate as it matches the forecasting horizon of the financial projections. The equity risk premium is assumed to be equal to 7%. Using these assumed parameters, the CAPM equation gives us a required return on equity of over 27%. These calculations have been shown in the attached spreadsheet.
The high return on equity implies that the restructured company has to be highly profitable in order to meet the expectations of its equity investors. The attached spreadsheet also calculates the free cash flows to equity holders using the data provided in exhibit 9 of the case study. The cash flows to equity remain negative in all of the next five years except 2001. In 2001, the cash flows only become positive because of a net debt issuance of $222 million. Without this debt issue, the cash flows would have been negative in 2001 as well. Moreover, the fixed assets of the company are declining over the forecasted period, which means that the forecasted capital expenditures are either understated or inadequate from a long-term perspective. Moreover, the debt ratio of the company remains at a very risky level even after five years of forecasted operations. This means that any adverse changes in the forecasted amounts have the potential to push the company into another default. This is especially risky scenario since the projections, prepared by Bear Sterns, may be overestimated. This is because the compensation of Bear Sterns has been linked to the approval of the restructuring plan. The plan puts the bondholders in a more risky position as their debt is converted into equity and the equity is expected to decrease in value over the next five years. The only positive in the projected statements is the growth rate of income, which is increasing consistently. However, there are reasons to believe that the growth rate implied by these earnings may be overestimated which will further decrease the value of the restructured company.
6- Does the order in which the holding company and subsidiary go bankrupt have any influence on the expected returns for each stakeholder group?
The bankruptcy of Marvel Entertainment Group is being treated separately from the bankruptcy of its holding companies. Therefore, the secured creditors of Marvel have a priority in claims towards the assets of the company. The bondholders who were issued debt through the holding companies can only claim the residual interest after the secured claims have been satisfied. On the other hand, there was a possibility that the bankruptcies of the holding companies and Marvel Entertainment were considered jointly because of the interlinked nature of the deal. If this were the case, bondholders would have much more leeway in negotiating a settlement. In such a case, the bondholders might have the option to propose their own restructuring plan since they would have been the majority stakeholder. It is highly unlikely that the bondholders would have gotten a priority claim over the secured debt holders (banks). This is because the claims of bondholders were secured against the equity of Marvel and the equity was not worth anything under any circumstances.
7- Why did the price of Marvel’s zero coupon bonds drop on November 12th, 1996? Comment briefly.
The announcement of 12th November did two things. First, it confirmed the fears that the company was heading towards a possible default. Although the fear of default had developed a month earlier when the company announced that it would violate its debt covenants, the announcement of restructuring served to remove any doubts about a possible recovery by the company. Second, the proposed restructuring plan was not in the best interest of the bondholders. The bondholders were expected to hold a majority stake in a restructured company, but the proposed new issue of 427 million shares intended to shift the balance of power back to Perelman. Both these factors went against the interests of bondholders. Under the assumption of efficient markets, it can be said the public did not know anything about the inside developments of the company. Therefore, the information about restructuring was not reflected in the price of bonds. After the announcement, the prices of the bonds dropped to reflect this new adverse information.
8- What is Icahn’s strategy? Should Icahn vote for the restructuring plan? Why or hay not?
The new structuring has been vehemently opposed by the bondholders of the Marvel holding companies. Although the bondholders, led by Icahn, are in favor of a restructuring, they feel that the current restructuring, as proposed by Perelman, does not adequately represent their interests. The main contention is that the price for the new shares paid by Perelman is well below the market. Potentially, Icahn does not want to lose control of the restructured company. This may be the reason that he suggested a rights offering in order to raise funds for the restructured company. Through a rights offering, Icahn would remain a significant shareholder in the company. Icahn specializes in buying distressed company and making money on the transaction. Therefore, he will also be looking for a clear exit strategy in addition to a positive return. If the bankruptcy of holding companies had been considered in conjunction with Marvel Entertainment Group, it would not have been surprising for Icahn to support liquidation and collect his share of the proceeds. Clearly, Icahn has no interest in the long-term direction of the company. The current restructuring plan promises no return for Icahn at least for the next five years. Even after five years, it is not clear if he will be able to generate any return from the transaction. Moreover, he will be reduced to a minority shareholder in the restructured company and will have no bearings in the affairs of the company. Therefore, it does not make sense for Icahn to support the restructuring plan.
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