Case study for Hugo Boss. Back on the profitable growth track and though still the right time to exit?

Teaching note on “Case study Hugo Boss: back on the profitable growth track and though still the right time to exit?”

Marc Paternot December 11 2012

Case overview

The case’s protagonist is Hugo Boss CEO, Claus-­‐Dietrich Lahrs, facing an important Board meeting on the following morning. Hugo Boss is owned by the Private Equity fund Permira, which has decided to exit its investment through a secondary buyout. Lahrs has to present the top management’s position on this strategic issue view including the other stakeholders’ opinions. This case allows students to dig into corporate governance frameworks, fashion/luxury business models and into exit strategies for Private Equity funds.

Teaching objectives

The case targets MBA or EMBA international students from diverse professional backgrounds in a Luxury Management course or Strategy course.

The teaching objectives of the case:

“After discussing this case, students will be able to…”

- Apply corporate governance models and theories to the case and in general to private corporations
- Define a Fashion/Luxury business model
- Identify the different exit strategies of a Private Equity fund
- Formulate from a stakeholder approach alternative exit strategies than the one chosen by the Private Equity firm Permira

Pedagogy

Specific concepts in the case

- Corporate Governance: models and theories
- Strategy: business models, firm and industry analysis, horizontal and vertical integration, organization design
- Corporate Finance: Cash Flows, Enterprise Value, Equity Value, Net Debts, Leverage, Valuation Ratios/Multiples
- Marketing: brands positioning, target groups, communication plans
- Sales: distribution channels mix

How to solve the problem

Here the proposed steps to solve the problem:

- Define Hugo Boss existing business model
- Analyse its corporate governance models and consider alternative governance options
- Take each exit option available, define it and list the pros and cons.
- For Permira’s decision (exit with a secondary leveraged buyout) calculate the return it could make in November 2012.
- Find out reasons why Permit could keep its investment in Hugo Boss.
- Present the point of view alternatively of Employees / State / Clients / Suppliers

Students’ outcome:

Write Lahrs’ presentation to the Board as mentioned in the case:

- Present Lahrs and top management’s position as a single recommendation based on these successive steps backed with arguments and figures.

Additionally, the class could be divided into four groups for a role-play:

- Group A “Permira exits with secondary buyout”
- Group B “Permira exits with an IPO”
- Group C “Permira exits with a sale to a strategic player”
- Group D “Permira keeps its investment in Hugo Boss”

Case Analysis

Four main concepts will be analysed as well as their practical application to this case study:

- Corporate governance models and theories
- Fashion/Luxury business models
- Investment exit strategies
- Valuation method and return’s calculation

Corporate Governance definitions

- Definition from Crane and Matten (2007): a set of processes and structures for controlling and directing an organization.
- Definition from Abu-Tapanjeh (2009): the process of decision-­‐making and the process by which decisions may be implemented.

Corporate governance models

There are two main models described in the corporate governance literature:

- Two-Tier and One-Tier Board models

This distinction was made clear by Mintzberg (1973) and backed by Fama and Jensen (1983 ) .

Abbildung in dieser Leseprobe nicht enthalten

Source: The Asia Law Network Blog (retrieved on March 31 2022)

The case clearly portrays a classical Two-­‐Tier model with a Supervisory Board (controlled by Permira) and a Management Board (led by Mr Lahrs).

- Insider and Outsider systems

The Insider model bank is bank-­‐based and the outsider model is market-­‐based financial system described in the table below by Sheridan and Kendall (1992):

Table 2.2

An Example of External Board Contingencies: The Distinction Between Insider and Outsider Systems

- outsider system (Anglo-Saxon countries);
- insider system (continental Europe and Japan);
- dispersed ownership and control; · concentrated ownership;
- separation of ownership from control;
- little incentive for outside investors to participate in corporate control;
- a climate where hostile takeovers are not unusual, and they can be costly and antagonistic;
- the interests of other stakeholders are not represented;
- low commitment of outside investors (whatever they may say in public!) to the long-term financial strategies of the company;
- takeovers may create monopolies.
- the association of ownership with control;
- control by related parties such as banks, partners and employees;
- absence of hostile takeovers; in fact, an aversion to them;
- the interests of other stakeholders are represented;
- the intervention of the outside investor is limited to periods of clear financial failure;
- insider systems may create collusion and cartels.

In the case, Hugo Boss governance is a more of an insider system (concentrated ownership, association of ownership and control, representation of stakeholders). One central question remains: even though some stakeholders are represented (in the Supervisory Board) are their interests heard and taken into account at shaping the group’s strategy?

Corporate governance theories

The fundamental theories in corporate governance started with the agency theory, expanded into stewardship theory and stakeholder theory and evolved to resource dependency theory, transaction cost theory and political theory. It is obvious that a combination of various theories best describes the governance of a corporation.

Agency Theory

It is defined as “the relationship between the principals, such as the shareholders and agents such as company executives and managers”. It expects the agents to act and make decisions in the principal’s interest. This theory was introduced as a separation between ownership and control. It suggests that it is well adapted in order to align the goals of the management with those of the owners.

Abbildung in dieser Leseprobe nicht enthalten

Source: Abdoullah & Valentine (2009) Agency Theory Model

Stewardship Theory

In this theory, company executives and managers are stewards working for the shareholders. They protect and make a profit for the shareholders (Davis, Schoorman & Donaldson, 1997). The theory suggests that stewards are motivated and pleased when success is attained. Nonetheless, they desire to have more autonomy and they like to manage their career in order to be seen as effective stewards of their organization.

Abbildung in dieser Leseprobe nicht enthalten

Source: Abdoullah & Valentine (2009) The Stewardship Theory Model

Stakeholder Theory

It can be defined as “any group or individual who can affect or is affected by the achievement of the organization’s objectives”. It suggests that the management in place has a network of relationships to take into account (suppliers, employees, political groups etc…). Clarkson (1995) sees the firm as a system, where the organization is to create wealth for its stakeholders. According to this theory, there should not be a dominant interest within the company.

Abbildung in dieser Leseprobe nicht enthalten

Source: www.economicpoint.com (retrieved March 31 2022)

Resource Dependency Theory:

It focuses on the role of the board of directors “in providing access to resources needed by the firm”. The directors bring resources to the company, such as information, skills, access to key actors and legitimacy.

Transaction Cost Theory:

It attempts to view the firm as an organization comprising of people with different views and objectives. Consequently, the combination of people with transactions (view, objective) suggests that managers are opportunists and arrange firms’ transactions to their interests.

Political Theory:

It suggests that the government participates in the corporate decision making with an entrance of politics into the governance structure of firms.

The case highlights a combination of theories. Permira has the interest to apply the agency theory in order to align management interests to those of the fund. The top management follows a stewardship theory in protecting shareholders’ interests and their own interests (freedom, autonomy). Furthermore, the stakeholder theory can be applied to the case as it brings the employees, the state and clients into the game.

Business model definitions

The two leading frameworks of the Fashion and Luxury management literature can best describe Hugo Boss business model:

- “The Pyramid Business Model” put by Kapferer and Bastien (2009):

Abbildung in dieser Leseprobe nicht enthalten

-The Four Blocks Model” put by Corbellini and Saviola (2009):

The business model consists of four blocks:

WHAT: customer value proposition – The offer to the market

WHOM: client segment – Targeted by the value proposition

HOW: value chain – Communication and distribution channels, vertical and horizontal integration and international scope.

WHO: model of corporate governance.

Applied to Hugo Boss (author’s representation):

Abbildung in dieser Leseprobe nicht enthalten

PE exits

Traditionally, there are for the Private Equity industry three routes to exit an investment, also known as “disinvestment”. The choice of a way to exit and more essentially its timing is one of the most debated choice faced by private equity funds. The choice of exit is very often planned at the start of the investment.

- Sale of the company to a strategic non financial buyer

Normally, it consists of a sale to a larger player in a similar industry or sector (vertical or horizontal integration). For the fund, it is an attractive solution as it results in a cash payment or shares of the buyer. It ends the partnership’s involvement with the firm. For the management, it is generally a critical situation. Very often the management is replaced following the acquisition.

- Sale to another private equity fund in a secondary leveraged buyout

It occurs when a Private Equity fund sells its investment to another Private Equity fund. It preserves the company’s independence and very often the management is kept (providing the performance of the company was good). Furthermore, the management often benefits of attractive compensation schemes with an interest to stay with the company till the next exit. It allows the Private Equity fund to sell all its shares of the portfolio company and returns the profit to their investors.

- Initial Public Offering

It can be a very attractive route as it often allows the highest valuation of the portfolio company and raises the reputation of the fund. Nevertheless the market conditions must be favourable otherwise this exit makes little sense. Additionally, lock-­‐up clauses prevent private equity firms from selling all or even any shares for a specific period after the IPO. Consequently, the fund does not end its investment at the transaction date and it delays the return granted to the fund’s investors.

Alternatives exits’ routes consist of a “Management Buy Out”, a “Recapitalization” or a “Liquidation”.

Implication for the case:

For Permira

Based on the data presented above, one understands that, as Permira holds its investment in Hugo Boss since 66 months, a sale seems from that perspective appropriate.

For Permira, the best exit decision end of 2012 seems indeed the secondary leveraged buyout:

- The turmoil of the stock markets of the past 3 years makes the IPO process unlikely to bring the expected valuation and return.
- Three “group structure” players, with an easy access to capital and in search of iconic brands complementing their portfolio of brands, could be interested in Hugo Boss: LVMH, PPR and Richemont. Therefore the sale to a strategic player seems a realistic option for Permira.
- Permira made the majority of its exits through a secondary buyout. This option makes sense as it offers a quick exit at fairly good conditions.

As majority shareholder, Permira is fully entitled to go for the secondary buyout route as it maximizes its returns and is in the philosophy of the Private equity industry. Permira needs to return the money back to their investors within the initial period of the fund Permira IV with the expected return.

The partners of Permira want to be rewarded by their carried interest. A sale enhances their reputation, which is critical to raise and close the next fund, Permira V.

But it leaves the question whether it is in the best interest of the other stakeholders? A secondary leverage buyout looks like a club of financial professionals constantly trading with one another in a sort of endless roundelay, leaving some questioning whether this is the best interest of the company and of all stakeholders.

For the management

Lahrs and his team made a meaningful investment in the company. This is a traditional practice in the industry in order to align the incentives of the fund to those of the management. The management has therefore an upside or a downside but only until the exit is reached. If things go well, this lucrative incentive (compared to large listed corporations) along with a stricter control exerted by the private equity shareholder (monthly board meetings, dozens informal meetings etc…) lead the management to deliver better results with a genuine use of cash and risks strategies. A sale to a strategic very often implies a change of management or new reporting lines resulting in less leadership on the business. An IPO can be a good way to exit for the management providing the market conditions are favourable. Usually, the management of a private equity’s owned company tends to favour a secondary buyout as it gets a new incentive scheme, which can be even more attractive than the present one.

For the employees

Any new ownership structure implies a change in the organization. The first group to be confronted with is the workforce. A new shareholder will put projects, businesses and people into question. A sale to a strategic very often results in synergies where in some functions overlaps exist. Resulting in lay-offs of employees (for instance in the sales force, in purchasing, in human resources, in finance). A secondary buyout can mean either the continuation of the strategic plan or a radical change over. An IPO could be favourable to the employees as it raises the reputation of the firm and usually implies in the first place minor changes for the workforce.

For the suppliers

No major changes are expected. The new shareholder can put suppliers into more competition to secure lower prices. It can happen that the terms of payment change to the advantage of the company. For the suppliers, the exit choice of Permira is not extremely relevant.

For the clients

A new ownership structure can imply (especially for a sale to a strategic player or a secondary leveraged buyout) a change in strategy. This may have an impact on the “Route to Market” and on the mix for Hugo Boss between wholesale and retail. As for a supplier, new terms of payment can be introduced in favour of the company. In this case, the clients could welcome an IPO, as it should hurt them the least.

For the state

This actor is always interested in keeping most of the jobs in the region and receiving the social contributions and taxes from the firm. From this perspective, an IPO seems the most favourable outcome, as the changes are less severe than the ones resulting from a sale to a strategic player or to a secondary buyout. In those two cases, the negative impact on the workforce and the tax optimization potential are more striking and worrying.

Valuations of Hugo Boss and Permira’s return

Entry Valuation:

May 2007

Enterprise Value (EV) = Market Value of Equity (MVE) + Net Debt 5.3 = MVE + 2.3

=> MVE = 3bn€

Permira investment is done through the holding owned with the Marzotto family, Red and Black, with 80%. Therefore Permira’s investment equals to 80% of MVE = 2.4bn€. It is unknown how much of that was financed by debt. We consider in the calculation that it is a truly equity investment from Permira.

Final Valuation:

November 2012

The company has a minimum level of net debt. The 2.3 bn€ debt attached to the deal was restructured in 2009 and reduced by 1/3 to 1.5bn€ and since then almost reimbursed through strong Free Cash Flows generated at Hugo Boss in the past 5 years.

From the Annual Report 2011, we conclude that the Net Debt level by December 31 2011 equals to:

“Financials Liabilities to Bank carrying interests” – “Cash and Cash equivalents”

= 349.4 – 200.4 = 149m€

Financial Liabilities Cash and cash equivalents:

Short term: 4.4m€ 200.4m€

Mid-term: 322m€

Long-term: 23m€

Total= 349.4m€

On November 15 2012: share price was 78.125€. Hugo Boss capital is composed of 70.4 millions shares. Therefore the Market Capitalization = 5.5bn€ = MVE.

As EV = MVE + Net Debt

EV = 5.5 + 0.149 = 5.649bn€

Hugo Boss Enterprise Value equals to 12 times Hugo Boss EBITDA 2011 (469m€) and 11 those of expected 2012 (516m€). This is in line with the sector’s average; Hugo Boss is not over valuated.

Permira’s return:

By November 2012 (investment made in May 2007)

It is needed to take into account the intermediate steps presented in the case:

- Repurchase in 2007 and 2008 by Red & Black of shares in Hugo Boss capital (from 51% to 72%): 500m€ (with 80%, Permira: 400m€)
- Sale by Red & Black of 6% share in November 2011 for 300m€ (with 80%, Permira: 240m€)
- Sale of Red & Black of 100% of Valentino in July 2012 for 600m€ (with 80%, Permira: 480m€)

Permira owns at the exit time 80% x 66% of Hugo Boss: 52.8%

Permira absolute return = – 2.4 – 0.4 + 0.240 + 0.480 + 5.5x52.8% = 0.824bn€ Permira relative return = 0.824/2.4 = 34.34% over 5.5 years

It is to note that the return could in case of a bid of strategic players even higher. For instance, if there is a share rally from 78.125€ to 89.85€ (+15%). the return for Permira would be + 52.5%.

Benchmark

Abbildung in dieser Leseprobe nicht enthalten

Source: http://markets.ft.com/research/Markets/Tearsheets/Summary?s=FTPP:FSI (retrieved on November 25 2012)

Permira ‘s alternative option

Even if Permira’s decision to exit is portrayed in the case, one could consider that keeping its stake in Hugo Boss (for instance until 2015 and the achievement of the “Strategic Outlook”) could make sense as well.

The goal is to attain an EBITDA of 750m€ by 2015. If they achieve 700m€ and the multiples stay the same (12 times), Hugo EV would be equal to 8.4bn€ without debt. Most probably, the stock would see a positive trend and the exit for Permira in three years could be even more favourable. The question remains: how much time do Permira’s executives have versus their Limited Partners of fund IV and how much versus the closing of the fund V?

Conclusion

This case on Hugo Boss allows both to analyze a leading fashion player (business model, corporate governance, strategy) and to dig into exit strategies for a private equity fund. This ownership and control structure came from the US into Europe in the 1990’s and has gained importance in the last ten years. It is obvious that all stakeholders cannot share the same opinion on the “best” exit strategy as they have asymmetrical objectives. Permira’s exit decision through a leveraged secondary buyout is fully rational (taking into account the timing and the return), even though alternative exit options or even keeping its stake in Hugo Boss are justifiable. The management position is more balanced just like the other stakeholders’ positions. The problem for the employees, the clients, the suppliers and the state is how to get their voice heard? Has the management an incentive to listen and to report their preferences to the shareholders?

References

Abu-Tapanjeh, A. M. (2009) Corporate Governance from the Islamic perspective: A comparative analysis with OECD prinicples, Critical perpectives on accounting, 20, 556-567.

Clarkson, M. (1995) A Stakeholder Framework for Analyzing and Evaluating Corporate Social Performance. The Academy of Management Review, 20, 1, 92-117.

Corbellini, E. & Saviolo, S. (2009) Managing fashion and luxury companies. Rizzoli Etas.

Crane, A. & Matten, D. (2007) Business Ethics: Managing Corporate Citizenship and Sustainability in the Age of Globalization, Oxford University Press.

Davis, J.H., Schoorman, D.F. & Donaldson, L. (1997) Toward a Stewardship Theory of Management. The Academy of Management Review, 22,1, 20-47.

Fama, E.F. & Jensen, M.C. (1983) Separation of ownership and control. The Journal of Law and Economics, 26,2, 301-325.

Kapferer, J.N. & Bastien, V. (2009) The Luxury Strategy. Kogan Page: London.

Mintzberg, H. (1973) The Nature of Managerial Work. Harper and Row: New York.

Sheridan, T. & Kendall, N. (1992) Corporate Governance: an action plan for profitability and business success. Pitman: London.

[...]