New Approaches to Retail Inventory Liquidation

New Approaches to Retail Inventory Liquidation

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In a world where times are changing at an ever-increasing rate, it is often the case that stereotypes do not keep up with reality. Danny DeVito in the movie Other People's Money depicts the stereotype most people have about liquidators. The companies that earn their living through liquidation work are stereotypically thought of as bottom-fishing scavengers that profit from the misfortune of others.

These stereotypes have become dated as more and more retailers find that liquidation can be a valuable means to an end. Further, the professionalism and sophistication of some liquidating firms have evolved so dramatically in recent years, many retailers have found that liquidators can be valuable partners with resources necessary to achieve certain goals.

Many of you are familiar with the "traditional" approach to inventory liquidation through a bankruptcy. The retailer reaches an agreement with a liquidating firm to conduct the liquidation. Bid packages containing assorted company information and a copy of the agreement with the liquidator are distributed to parties of interest including other liquidators. At the end of the notice period, a hearing is held where various liquidators bid until the highest and best offer is determined. Voila! A liquidation commences.

In some cases, however, new approaches being offered deserve serious consideration.

Preparing a Company for Liquidation

Many businesses choose to close stores within a division in groups rather than take the tough, but often necessary, step to close all stores of a given concept at one time. There are significant costs to a staged wind-down that cannot be easily quantified.

As employees see "the handwriting on the wall," loyalty and morale plummet. Dropping morale leads to marked increases in shrink (or inventory loss through internal and external theft and damaged inventory) from all sources. Internal theft will increase, justified by some as payback for the injustice of imminent store-closings. External theft will increase as employees are less diligent about security. Shrink from damaged merchandise will increase as apathetic employees take less care of the inventory. A protracted wind-down elongates the pain and increases a retailer's exposure.

Liquidation sales generate revenue in part because unusual value is offered on many items. Liquidation sales also generate revenue, though, based on the circumstance. In effect, a liquidation sale is a way for a business to liquidate its goodwill. The more powerful the circumstance, the more powerful the response from the public in the early stages of the sale when the discounts are low. Therefore, even if an entire division is not being closed at one time, there are significant economies to exiting a complete market at one time because it presents a much richer circumstance and there are obvious expense economies.

There are a number of factors that determine the eventual realization on inventory, but many of them are not usually considered by a retailer contemplating liquidation. Some examples are:

  • Promotions in effect just prior to and coincidental with liquidation. In determining the liquidation value of a retail inventory, the starting point is the current selling price. Many distressed retailers conduct significant off-price promotions just prior to liquidation; this can have a significantly detrimental impact on liquidation value.
  • You need the sizzle to maximize the value of the steak. From a consumer point of view, "bad" stuff is more attractive if it is sitting on a sales floor next to "good" stuff. If a retailer allows all the most desirable inventory to deplete before commencing a liquidation, the aggregate realization can go down measurably. No one would suggest that a retailer stock-up on good stuff before a liquidation, but the process of keeping inventory balanced can be quite valuable in producing the best overall economic result.
  • Media planning. One of the most costly line-items associated with a liquidation is the retail advertising. Very often, the traditional bankruptcy approach to liquidation results in a fire drill by the liquidator to prepare and execute a media plan for the event. The last-minute nature of a traditional approach often means that the liquidator is forced into paying top dollar for media. Planning can mitigate these costs, which can have a measurable impact on the realization.
  • Landlord issues. There is no landlord that welcomes a liquidation sale to his mall or shopping center. Such a sale has a double-negative impact from the landlord's perspective. First, the property looks less desirable if a retailer has failed at that location. Second, short-term increases in volume by the liquidating store come, to a certain extent, at the expense of other merchants. Even though experience shows that such negative effects claimed by on-going merchants tend to be exaggerated, the landlord's life is nonetheless less pleasant while this activity is going on.

Without the proper preparation, a courtroom can be a place where (sometimes many) landlords can become obstructionists to court approval for a liquidation. With proper preparation, the issues can be understood and dealt with in advance of the hearing for final approval; the whole process becomes much more fluid. Landlords and liquidators can end up working together to accommodate their mutual interests.

Asset protection plans cannot begin too early. Irrespective of a retailer's prior shrink experience, loyalty from customers and employees is at an all time low prior to store closures. Many retailers feel they can keep secret such plans to close stores, however, more often than not such decisions make their way through the retailer's grapevine long before a public announcement.

These are examples of ways that planning can lead to maximizing value. How are these ideas then converted into a new approach?

Retailers have now begun retaining liquidating firms to help prepare the business prior to liquidation. A fee to a liquidating firm for helping prepare the business can be an investment with a very high return. More and more cases involve enormous amounts of inventory where even a one percent increase in inventory value realized can mean material financial upsides. The services provided by such a liquidation consulting firm can include everything from participating in strategic decisions to improve eventual liquidation value to preparing of materials for distribution to potential bidders. A better and more comprehensive bid package can mean more aggressive bidding.

New Structures for Service Providers

Before explaining a few new structures, here are some of the concerns about the traditional approach.

The traditional approach to inventory liquidation often creates an adversarial relationship between the retailer and the service provider. With every year that passes, the competition among different liquidators has become more and more fierce with liquidator margins eroding. High guarantees (or investments) by liquidators has meant that liquidators have been forced to insist on very meticulous enforcement of the terms of the agreement, extremely careful valuation of the inventory to be liquidated and an ever-increasing desire on the part of liquidators to keep all or the lion's share of the upside (in the event of an extremely successful sale). These tensions on margin have diminished the relationship that is necessary to truly maximize the realization on the inventory: a true partnership between the liquidator and the retailer.

New structures, beginning to emerge only very recently, are made possible because:

  • Both parties benefit from a structure where there is a community of interests as opposed to conflicting interests.
  • The retailer is attracted by a structure where it is to retain more control over the process. Such control may allow the retailer to protect certain long-term interests or interests that may conflict with the goals of the inventory liquidation.
  • Retailers have come to learn that there is not a great deal of risk in liquidating retail inventory if the process is spearheaded by an experienced liquidator.
  • Liquidators are entrepreneurial enterprises willing to "gamble" their income on their performance.
  • Creditors have a greater opportunity to enhance their final distributions from the estate because the costs of the liquidator's services can be reduced.

One example of such a new structure involved the final inventory liquidation for a chain of home centers. They had conducted prior liquidations under the traditional approach and were ready to try a new approach. In this final liquidation, the liquidator received no fee until the outcome surpassed a certain threshold. Then, once past that threshold, there was a sharing arrangement, largely in the retailer's favor, for the balance of the proceeds.

Another example of a new structure is where the liquidator provides the retailer with "earthquake insurance." In this case, there is a guarantee provided by the liquidator, but the guarantee is at a level where the liquidator does not believe they have any real capital risk, so this insurance is not costly. Then, past a certain threshold, the liquidator earns a defined fee and captures only a small percentage of the upside. Again under this structure, the retailer is able to preserve most of the upside (while protecting against a catastrophic outcome).

In addition to the benefits above, there are also some real cost savings. There is no need for a physical inventory to be taken. Some of the retailer's staffing could be used to supervise parts of the liquidation thereby lowering certain payroll-related costs.

These are just a few examples of how the traditional structure (both before liquidation and the liquidation itself) is evolving. With the growing challenges of managing bankruptcy cases, these innovative structures provide an opportunity for all parties to work together to achieve a better result.

Journal Date: 
Wednesday, October 1, 1997