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Department of Accounting and Finance

AG915 Advanced Corporate Finance and Applications

Case Study
Internal Capital Markets
Next & New Look

Group 12

Pedro Coelho da Silva Feteiro 201785349


Nikolaos Karakaisis 201794685
Anastasios Lingis 201772279
Moritz Meyer 201763498

Dr. Amandeep Sahota

28th March 2018

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Table of contents

1 Introduction ………………………………………………………………………..……….. 8
2 Financial analysis of New Look ….………………………………………………………… 9
2.1 Profitability ratios ……………………………………………………………..….. 9
2.1.1 Return on capital employed ………………………..………………….. 10
2.1.2 Return on shareholders’ funds ……………..………………………….. 11
2.1.3 Gross profit margin ……………..…………….……………………….. 12
2.1.4 Net profit margin ………………………………………………...……. 14
2.2 Liquidity ratios ……………………….…………………………………………. 15
2.2.1 Current ratio ………………………………………………………..…. 15
2.2.2 Quick ratio (Acid test) ………………………………………………… 16
2.3 Efficiency ratios ………………………………..……………………………….. 17
2.3.1 Inventory turnover ……………………………………………..……… 17
2.3.2 Receivable days ……………………………………………………….. 18
2.3.3 Payable days …….…………………………………………………….. 19
2.3.4 Cash conversion cycle ………………………………………………… 20
2.4 Financial structure ratios ……………………………………………..…………. 21
2.4.1 Gearing ……………………………………………………………...… 21
2.4.2 Interest cover ………………………………………………………….. 23
2.5 Segment level performance ………………………………………………….….. 24
2.6 Interim summary ..………………………………………………………………. 27
3 Internal capital markets …………………………………………………………………… 27
3.1 Benefits of internal capital markets ……………………………………..………. 28
3.2 Drawbacks of internal capital markets ……………………………………..……. 30
3.3 New Look acquisition and internal capital markets value ……………….…….. 33
3.3.1 Case study Chilean Groups 1990 - 2009 ………………………..…… 33
3.3.2 Case study Indian Business Groups 1989 - 2001 …………………….. 34
3.3.3 Case study Korean Business Groups (chaebol firms) …………….…… 35
3.3.4 Case study conglomerates and industry distress ………………………. 37
3.4 Interim summary …………………………………………………………..……. 38
4 Next’s corporate governance and ownership structure ……………….………..………….. 39
4.1 UK corporate governance code …………………………………………………. 39

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4.2 Board structure and directors of Next ………………...…………………………. 40
4.3 Next’s ownership structure ……………..…...………………………….……….. 42
4.4 Effect on Next’s internal capital market ………………………………………… 44
5 Acquisition of New Look ……………………………………….………………………… 45
5.1 The private equity firm Brait ……………………………………………………. 45
5.2 Acquisition of New Look ……………………………………………………….. 46
5.3 Interim summary ..…………………………………………………….………… 51
6 Costs and benefits of New Look as a standalone company ………..…………..………….. 52
6.1 Benefits of a standalone company ………………………………………….…… 53
6.2 Costs of a standalone company ………………………………………………….. 54
6.3 Interim summary ………..………………………………………………………. 56
7 Recommendations ………………………………………………………………………… 57
7.1 Maximising limited partners return ………………….………………………….. 57
7.1.1 Initial public offerings ………………………………………………… 57
7.1.2 Secondary buyout ……………………………………………………... 59
7.1.3 Trade sale to a strategic buyer ………………………………...……….. 60
7.1.4 Interim summary ……………..……………………………………….. 61
7.2 Best interest of New Look ………………………………………………………. 62
Appendices ………………………………………………………………………...……….. 64
References ……………………………………………………………….………………….. 68

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Table of graphs
Graph 1: Return on capital employed …………………………………..…………………… 10
Graph 2: Return on shareholders’ fund ………………………………………………..…….. 11
Graph 3: Gross profit margin ……………………………………………………………… 13
Graph 4: Net profit margin …………………………………………………………..……. 14
Graph 5: Current ratio …………………………………………….…………………..…….. 15
Graph 6: Quick ratio …………………………………………………………………….… 16
Graph 7: Inventory turnover ………………………………………………………………. 17
Graph 8: Receivable days …………………………………………………………….…… 18
Graph 9: Payable days …………………………………………………………………….. 20
Graph 10: Cash conversion cycle ………………………………………..………………….. 21
Graph 11: Gearing ……………………...…………………………………………………… 22
Graph 12: Interest cover …………………………………………………………………... 23
Graph 13: Number of IPOs and sum of money raised ………………………………….…. 59

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Table of figures
Figure 1: Segmental report revenue ………………………………………………….……. 25
Figure 2: Segmental report operating profit …………………………………………………. 26

5
Table of formulas
Formula 1: Return on capital employed …………………………….…………..…………… 10
Formula 2: Return on shareholders’ fund ……………..…………………………………….. 11
Formula 3: Gross profit margin ………………………………………..…………….……… 12
Formula 4: Net profit margin ………………..………………………………………………. 14
Formula 5: Current ratio ……………………………………………………………....…….. 15
Formula 6: Quick ratio ………………………………………………..………………..…… 16
Formula 7: Inventory turnover …………………………………………………….……… 17
Formula 8: Receivable days ………………………………………………………....……… 18
Formula 9: Payable days ………………………………………………….………………… 19
Formula 10: Cash conversion cycle …………………………………………………………. 20
Formula 11: Gearing ……………………………………………………………………… 22
Formula 12: Interest cover …………………………………………………………..…….. 23
Formula 13: Discounted cash flow method …………………………………………..…… 46
Formula 14: Discounted cash flow method perpetuity ……………………………...…….. 45

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List of abbreviations
Apax Partners Limited Liability Partnership Apax Partners
ASOS Public Limited Company Asos
Brait Societas Europaea Brait
Chief executive officer CEO
Discounted cash flow DCF
External Capital Markets ECM
Financial Conduct Authority FCA
Great British Pounds GBP
Gross profit margin GPM
Initial public offer IPO
Internal Capital Markets ICM
Laura Ashley Public Limited Company Laura Ashley
Limited partner LP
Marks and Spencer Public Limited Company M&S
Merger and acquisition M&A
Net profit margin NPM
New Look Retail Group Limited New Look
Next Public Limited Company Next
Permira Advisers Limited Liability Partnership Permira
Private equity PE
Research and development R&D
Return on capital employed ROCE
Return on equity ROE
Return on shareholders’ funds ROSF
Secondary buyout SBO
UK corporate governance code The code
United Kingdom UK
United States of America US

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1 Introduction

New Look Retail Group Limited (New Look) is an international multichannel retail brand,

offering value-fashion for women, men, and teenage girls. The company has more than 900

stores, which are mostly based in the United Kingdom (UK). Its e-commerce grew sustainably

over the last years and serves customers in 120 countries worldwide. Since 2015, New Look is

owned by Brait Societas Europaea (Brait), a private equity (PE) firm.

It is now rumoured that the UK based retailer Next Public Limited Company (Next) is

preparing a takeover bid for New Look. This report tries to examine the firm’s decision for the

new acquirement by analysing New Look’s performance in the last five years, internal capital

markets (ICM), corporate governance and ownership structure, as well as advantages and

disadvantages of acquiring a firm backed by a PE investor. Finally, the last element of the

analysis is the evaluation of the benefits and costs of New Look as a standalone firm, if Brait

would undertake successfully an initial public offering (IPO) process to exit from New Look.

In the conclusion, we provide a recommendation for the exit strategy of Brait from New Look,

if the objective is either to maximise the return to the Limited Partners (LPs) or Brait acts in

the best interests of New Look.

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2 Financial analysis of New Look

In this section, we attempt to provide a financial analysis of New Look over the period 2013 to

2017. The financial analysis is mainly focused on the profitability, liquidity, efficiency and

capital structure of the company during this five-year period and the purpose of it is to observe

New Looks’ performance. To analyse the performance of New Look better, we calculated a

market average to compare the performance with the following four companies: Marks and

Spencer Public Limited Company (M&S), Debenhams Retail Public Limited Company, ASOS

Public Limited Company (Asos) and Laura Ashley Public Limited Company (Laura Ashley),

which are representing, among New Look and Next, the six largest UK retailers.

In general, financial analysis contributes to a better understanding of a company’s performance

as well as its financial position and structure. However, since no one can come to conclusions

based only on absolute numbers, the analysis is being implemented with the help of various

major ratios per category that is being examined and compared to the calculated industry

average. We acknowledge the fact that we are comparing a privately held company with

publicly listed ones and, as stated by Clor-Proell and Maines (2014), there are significant

differences between their financial reports. Subsequently, the performance of all ratios is being

measured over time in order to help to identify if New Look is profitable, has a good future

prospect, is growing and how it is structured.

2.1 Profitability ratios

Profitability ratios show whether the company is generating a sufficient return for its owners,

as manager’s incentive is to maximise shareholders’ value (McLaughlin and Henderson, 2017).

We take a closer look at return on capital employed (ROCE), return on shareholders’ funds

(ROSF), gross profit margin (GPM) and net profit margin (NPM).

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2.1.1 Return on capital employed

There are a lot of ratios that contribute to businesses’ profitability measurement. ROCE is an

important measure of business performance which expresses the relationship between the profit

generated by the business and the long-term capital invested in it. Therefore, this ratio shows

how efficiently a company employs capital, long-term borrowings and equity in order to make

net profits before interest payment and taxes.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑎𝑡𝑖𝑜𝑛


𝑅𝑂𝐶𝐸 = × 100
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 7 𝑓𝑢𝑛𝑑𝑠 + 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡

Formula 1: Return on capital employed

As it is easily understandable, it is always desirable to be as high as possible.

Return on capital employed


25%

20%

15%

10%

5%

0%
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

ROCE each year Average

Graph 1: Return on capital employed

In the case of New Look, we observe that the company increased its ROCE from 2013 to 2015

to 14.99 percent. In the following two years it dropped to 7.52 in 2017. But during the five-

year period New Look always performs under the industry average. Only from 2013 to 2015 it

was possible to perform in the opposite direction than the industry average moved. The average

dropped from year to year to its minimum of 19.61 percent in the year 2015, which is

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nevertheless 4.62 percent above ROCE from New Look. Unfortunately, New Look was not

able to keep the increase of its ROCE until 2017. It followed the market trend and dropped.

The industry average was falling therefore to its lowest level to 13.98 percent in 2017, while

New Look was only able to reach a ROCE in the amount of 7.52 percent. The changes over

the years of New Look only appear to the changes in the profit before interest and taxation.

The equity and non-current liabilities stayed almost at the same level over the five-year period.

However, ROCE of New Look was always below the industry average.

2.1.2 Return on shareholders’ funds

Similar to ROCE, ROSF shows the relationship between the invested equity capital and the

profit generated by the business.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑎𝑏𝑙𝑒 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠


𝑅𝑂𝑆𝐹 = × 100
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 7 𝑓𝑢𝑛𝑑𝑠

Formula 2: Return on shareholders’ funds

Return on shareholders' funds


25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

ROSF each year Average

Graph 2: Return on shareholders’ funds

In the case of New Look, the trend seems to be more or less similar to the one of ROCE. In

terms of this ratio, it is positive except the year 2013 and 2015 where it was -1.08 percent and

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-16.89 percent respectively. But in the case of New Look we have to be careful, because the

net profit is Great British Pounds (GBP) -53.6 million in 2014, GBP -34.4 million in 2016 and

GBP -20.2 million in 2017. It was only possible to generate a positive net profit in the years

2013 and 2015, which are GBP 3.4 million and GBP 52.9 million respectively. In addition, it

appears that New Look had a negative equity over the whole five-year period. These

circumstances are the reason for a negative ROSF in 2013 and 2015. Due to this fact, a

comparison with the industry average, where all companies had positive net profit and equity,

is difficult and not meaningful. However, we need to highlight that in years 2014, 2016 and

2017 we have a loss and in 2013 and 2015 a profit. Having said that, a negative equity entry

over the years makes ROSF not comparable to the industry averages.

2.1.3 Gross profit margin

GPM measures the profitability of a company based on its revenue and cost of sales,

disregarding all the other expenses. Therefore, it measures the profitability depending on the

business model in buying, producing or selling goods before any other expenses are taken into

account. Using it for comparison requires carefulness as gross profit margins vary significantly

depending on the nature of business and production.

𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = × 100
𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Formula 3: Gross profit margin

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Gross profit margin
60%

50%

40%

30%

20%

10%

0%
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

GPM each year Average

Graph 3: Gross profit margin

New Look has a better GPM than the industry average over the whole five-year period. It is

very stable and every year over 50 percent with a maximum in year 2014 of 52.79 percent and

a minimum in year 2017 of 51.34 percent. The industry average is constant as well over this

period with a maximum of 35.7 percent in 2013 and a minimum of 33.53 percent in 2017. It is

important to say that M&S is not included in the industry average because they did not publish

a gross profit as well as cost of sales. New Look is therefore every year around 15 percent

higher than the industry average. Reasons are significant lower cost of sales compared to the

revenue of the industry average. But New Look had very high administrative expenses

compared to the industry average. Given that, one of New Look’s biggest expenses is

administrative expenses, Next might have the expertise and knowledge to reduce this cost

significantly through synergies as we explain later in section five. It can be possible that they

booked some expenses under administrative expenses instead of under cost of sales.

Unfortunately, they do not provide information in the notes about this fact.

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2.1.4 Net profit margin

NPM is indicating what percentage of revenues remains after all costs, expenses, interest and

taxes are paid.

𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = × 100
𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Formula 4: Net profit margin

Net profit margin


6%

4%

2%

0%

-2%

-4%

-6%
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

NPM each year Average

Graph 4: Net profit margin

In the case of New Look, NPM was only positive in the two years 2013 and 2015, where they

had a net profit. This concludes in a positive NPM of 0.23 percent and 3.74 percent

respectively. In the years 2014, 2016 and 2017 they realized a loss which results in a negative

NPM of -3.92 percent, -2.31 percent and -1.39 percent. In contrast to New Look the industry

average was every year positive but with a negative trend over the five-year period. The

company performed every year significantly under the industry average except from 2015

where the average was 4.48 percent and New Look only had a difference of 0.74 percent.

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2.2 Liquidity ratios

Liquidity is company’s ability to turn assets into cash in order to pay liabilities and other

obligations. We take a closer look at current ratio and quick ratio or also known as Acid test.

2.2.1 Current ratio

Current ratio is the best way to measure the company’s liquidity based on current assets with

current liabilities of the company.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Formula 5: Current ratio

Current ratio
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

CR each year Average

Graph 5: Current ratio

New Look’s liquidity was measured by current ratio better in every year over the five-year

period from 2013 to 2017. It is every year over 1.0, which means that current assets are greater

than current liabilities. The highest current ratio was in 2015 which was 1.43. The lowest

current ratio was in 2013 and was 1.04. Compared to the industry average the liquidity of New

Look is better each year. The industry average remains almost stable around 1.0. The current

ratio of New Look indicates that the company has a better liquidity management than its

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competitors and can pay in theory every short-term liability because of the ratio greater than

1.0, as an interpretation of the formula.

2.2.2 Quick Ratio (Acid test)

Quick ratio is similar to the current ratio with the difference that inventory is being deducted

from current ratio. As it is more difficult to turn assets into cash, this ratio provides a more

realistic image of company’s liquidity.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠


𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Formula 6: Quick ratio

Quick ratio (Acid test)


1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

QR each year Average

Graph 6: Quick ratio

Quick ratio of New Look moved the same way as current ratio, because the inventories, which

are deducted from current assets, are almost the same over the five-year period. The minimum

of quick ratio is in the year 2013 of 0.62. The maximum is 2016 with a quick ratio of 0.89.

However, quick ratio is every year significantly above the industry average which speaks for a

good liquidity management of New Look.

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2.3 Efficiency ratios

McLaughlin and Henderson (2017) argue that efficiency ratios provide an understanding of the

company’s management with the working capital. We take a closer look at inventory turnover,

receivables days, payables days and cash conversion cycle.

2.3.1 Inventory turnover

Inventory turnover is a ratio that measures the average period in days for which stocks are

being held. It is also a measure of value and liquidity, which makes it important for investors

and creditors, as they always want to know how valuable a company’s inventory is and how

fast a firm can convert its inventory into cash.

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = × 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

Formula 7: Inventory turnover

As expected, it is desirable for this period to be as short as possible as it reflects how quickly

cost of sales can be converted into cash.

Inventory turnover
120

100

80

60

40

20

0
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

Inventory turnover each year Average

Graph 7: Inventory turnover

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As observed by current ratio and quick ratio New Look has a good liquidity management.

Inventory turnover proves this statement. The company has a shorter time period regarding

how long inventory was spending on the shelf before it was sold. Due to the seasonal business

of a fashion retailer a shorter inventory turnover is beneficial. The inventory turnover of New

Look was very stable over the five-year period with an average of 78 days. New Look was able

to have a shorter inventory turnover period than the industry averages each year. M&S is not

included in the calculation of the industry average because they did not publish the cost of

sales, which makes it impossible to calculate inventory turnover for them.

2.3.2 Receivable days

This ratio calculates in days how long, on average, credit customers take to pay the amounts

that they owe to the business and how quickly companies collect these payments.

𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 = × 365
𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Formula 8: Receivable days

Receivables days
35

30

25

20

15

10

0
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

Receivables days each year Average

Graph 8: Receivable days

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Again, it is desirable for this ratio to be as short as possible. The quicker the debtors pay the

company, the better for the company’s cash flow. In the case of New Look, it is very easy to

detect the effectiveness of the company over the five-year period. It was very stable with an

average of 20 days. New Look was able to not follow the industry average upper trend from

the year 2015 until 2017, which supports its cash management. Only 2013 and 2015 was the

industry average slightly below New Looks receivable days.

2.3.3 Payable days

This ratio measures in days how long, on average, the company takes to pay out their trade

creditors.

𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 = × 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

Formula 9: Payable days

In contrast with receivable days, in this case, it is preferable for the company to delay the

payments to its suppliers for some time to finance itself in the short-term. However, caution

needs to be taken in the payable days level of the company, as too many days can signal that

the firm is not in the position to meet its payments which is disadvantageous.

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Payables days
160
140
120
100
80
60
40
20
0
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

Payables days each year Average

Graph 9: Payables days

The payable days of New Look are constant over the observed period. It has a minimum of 129

days in 2013 and a maximum of 145 days in 2015. Roughly said, it followed almost the industry

average over the time. M&S is not included in the industry average, like for inventory turnover,

because they did not publish the cost of sales, which makes it impossible to calculate the

payable days for them.

2.3.4 Cash conversion cycle

This ratio measures the average number of days that working capital is invested in operations.

More specifically, it indicates the length of time cash spends tied up in current assets. It shows,

therefore, the time difference between outlay of cash and cash recovery.

𝐶𝑎𝑠ℎ 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑐𝑦𝑐𝑙𝑒 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠

Formula 10: Cash conversion cycle

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Cash conversion cycle
20
10
0
-10
-20
-30
-40
-50
-60
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

Cash conversion cycle each year Average

Graph 10: Cash conversion cycle

The cash conversion cycle of New Look is negative for each year of the observed period. This

leads to the conclusion that the company can finance a part of its business itself only through

the difference between the outlay of cash and cash recovery. The time between the outlay and

the recovery is the same as a short-term loan without interest expenditures. New Look has the

best cash conversion cycle in the year 2014 with a value of -49 days and the worse value of -

33 days in 2017. Nevertheless, it had better figures each year than their competitors measured

by the industry average. Excluded for the industry average for the cash conversion cycle is

M&S because we were not able to calculate inventory turnover and payable days for it.

2.4 Financial structure ratios

McLaughlin and Henderson (2017) claim that this category of ratios indicates the way that the

firm is financed. Two very important ratios for this purpose are gearing and interest cover.

2.4.1 Gearing

Gearing shows the composition in long-term financing of a company.

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𝐿𝑜𝑛𝑔-𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡
𝐺𝑒𝑎𝑟𝑖𝑛𝑔 = × 100
𝐿𝑜𝑛𝑔-term debt + equity

Formula 11: Gearing

It is very important to mention that the higher the proportion of debt for a company’s structure,

the higher the gearing and exposure to risk.

Gearing
160%
140%
120%
100%
80%
60%
40%
20%
0%
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

Gearing each year Average

Graph 11: Gearing

McLaughlin and Henderson (2017) consider that it is not so easy to have a general rule to

indicate whether a specific level of gearing can be considered as acceptable or not. They

explain that it depends on the firm’s ability to support its earnings with security and stability

and also on the attitudes of lenders. It is useful to mention that in the UK, a company is regarded

as highly geared if it has reached a gearing ratio of 40 percent (Department for Environment,

Food & Rural Affairs, 2014). In our case, we can see New Look had a gearing over 100 percent

over whole five-year period, which is due to the negative equity. The highest gearing was in

the year 2014 with 142 percent. The lowest gearing was 2016 with 130 percent. However, the

trend line of New Look’s gearing is stable over the observed period. Nevertheless, compared

to the industry average New Look had a significant higher gearing than their competitors. Asos

is not included in the calculation of the industry average because they are almost only financed

22
by equity and short-term debt, which it is not very representative for the average in our opinion.

However, the industry average is stable as well but with an average of 41 percent which is

regarded as highly geared, according to the Department for Environment, Food & Rural Affairs

(2014). The high gearing of New Look shows that the company’s risk is very high as lenders

can demand higher finance payments due to the possibility of bankruptcy.

2.4.2 Interest cover

With the help of this ratio we have the ability to quantify the capacity of the company to meet

interest payments out of operating profits.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥


𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

Formula 12: Interest cover

Interest cover
8
7
6
5
4
3
2
1
0
2012/2013 2013/2014 2014/2015 2015/2016 2016/2017

Interest cover each year Average

Graph 12: Interest cover

The result of this ratio in this five-year period is another example of the high level of New

Look’s debt. More particular, it is significantly below the industry average. New Look’s

maximum interest cover was 1.29 in the year 2015 and its minimum 0.76 in the following year.

The industry average, on the other hand, had a maximum of 7.55 in 2016 and a minimum of

23
5.24 in 2014, which is much more than New Look had. Excluded for the industry average for

interest cover are Asos, because they did not publish interest expenses in 2016 and 2017, and

Laura Ashley, because it had not very representative ratios for the industry, in our opinion.

2.5 Segment level performance

The ability to have information about the segments’ performance inside a company is

beneficial for all parties, which are acting with the company. Furthermore, segments’

performance allows analysts to calculate the financial ratios for each segment, contributing to

a better understanding of the firm as a whole. However, as mentioned by McLaughlin and

Henderson (2017), UK companies are not required to publish a lot of information about their

segments. Thus, the same authors believe that it is difficult to accumulate data that could lead

to any results about segments’ performance. Moreover, in this particular accounting area, the

lack of standardisation contributes negatively to this problem. There is no general agreement

on the definition of segments, nor how costs that have to do with these segments should be

published.

24
Figure 1: Segmental report revenue (New Look, 2017)

In the case of New Look, we are lucky enough that the company provided some data about the

five segments’ UK retail, e-commerce, 3rd party e-commerce, international and franchise.

Furthermore, they split up between UK and international. In more details, as stated in the

annual report, the most important measures to estimate the performance of the two different

segments, that have been established since that time, are revenue and total underlying profit.

As it is obvious by the time that the data had been collected, the UK retail segment appears to

constitute the main source of revenue for the firm. More particularly, UK retail segment’s

revenue is GBP 972.3 million out of the total GBP 1,454.7 million of the firm until the 25th of

March 2017. The second biggest segment’s revenue comes from e-commerce which is GBP

230.0 million. It is important to say, that over 82 percent of the revenue was generated in the

UK with an amount of GBP 1,202.3 million out of the total GBP 1,454.7 million. Only GBP

270.6 million are generated internationally. But we can see over the last five years an increase

in the revenue generated international while the total revenue approximately is stable.

25
Figure 2: Segmental report operating profit (New Look, 2017)

In the segmental report regarding the operating profit for each of the five segments of New

Look we can see how the total operating profit of GBP 97.6 million splits up to each segment.

The segment with the highest operating profit is UK retail with GBP 70.5 million, which is 72

percent of the total operating profit of New Look. The second biggest operating profit was

earned by the segment E-commerce with GBP 24.6 million. 3rd party e-commerce and

franchise earned GBP 16.6 million and GBP 6.5 million respectively. The fifth segment

international has an operating loss of GBP 20.6 million. This loss was increased from GBP 8.8

million in the year 2016 due to international expansion strategies.

Moreover, New Look states operating profit as well as the revenue composition between

operating profit in the UK and internationally over all five segments. The operating profit in

the UK is GBP 95.1 million which is 97 percent. Only the remaining 3 percent in the amount

of GBP 2.5 million was earned abroad.

26
2.6 Interim summary

To sum up, in terms of profitability, New Look had a loss in three of the last five years.

Subsequently, the ratio comparison with the industry average is not the best illustration of

reality and this is because we observe that equity is negative for each of the five years.

However, New Look performs well in liquidity ratios compared to the industry. Also, the

efficiency ratios are better compared to the average. A negative cash conversion cycle allows

the company to finance itself with the difference between cash outlay and cash recovery.

Nevertheless, the financial structure of New Look is not advantageous compared to the industry

average. By virtue of the loss in three of the five years we do not think the negative equity can

be reduced. Generally, New Look has some significant disadvantages when compared with the

industry average. More specifically, administration costs, gearing and profitability signal that

New Look is not in the best financial position possible. On the other hand, New Look

outperforms in terms of liquidity and inventory management indicating their superior position

over the industry average. Thus, Next needs to carefully examine the disadvantages and

evaluate the possibility of improving them before proceeding with the acquisition. We strongly

believe that if Next is capable of improving some of these major disadvantages it can benefit

from liquidity and inventory management as well as synergies that we explore in later sections.

3 Internal capital markets

It is planned, that New Look will operate as a subsidiary of Next and hence, in this section we

are going to focus on the financial synergy created by this acquisition, and more precisely on

the ICM.

ICMs are used by multi-divisional firms allowing the parent company to internally allocate

resources across divisions avoiding any adverse frictions with the External Capital Markets

(ECMs) (Hovakimian, 2009). As the author further argues, this choice has a significant positive

27
or negative impact on the firm’s efficiency and thus, value. With an ICM all resources will be

gathered to the parent company and redistributed later on to divisions. The allocation of

resources to divisions is performed by the managers, however, the decision to undertake

particular investment projects is based on a divisional level. In other words, Next’s managers

have the authority to reallocate resources between the various divisions and hence, divisional

managers, for example, New Look’s manager will independently choose investment projects.

As Lamont (1997) explains, ICMs act as major channels to distribute capital within firms where

managers distribute resources to various divisions. An important characteristic of ICMs is the

major difference between ICMs and ECMs that arises from the ownership and resource

allocation relationship as explained by Gertner, Scharfstein and Stein (1994). More

specifically, in ICMs the residual control rights over the company’s assets remain within the

entity that provides the capital (Grossman and Hart, 1986). Thus, the entity that allocates

capital, for example, Next’s chief executive officer (CEO), has authority over the various

divisions whereas in ECMs, capital providers or lenders, such as banks, do not. The wider

literature examines both the bright and dark side of ICMs, which is depended on many factors,

such as, the nature of the group and economic conditions and they can add or destroy value.

We will continue by examining both benefits and drawbacks arising from ICMs to better

understand how they function.

3.1 Benefits of internal capital markets

To start with, the most important benefits arising from ICM are the more money and smart

money referred to by Stein (2003). More money refers to the fact that diversified firms are able

to raise more external financing compared to standalone firms as a result of their uncorrelated

cash flows. This becomes even more important in cases where the firm suffers from

underinvestment as the parent company will unlock more resources and through ICMs

28
distribute resources to expand investments. This is confirmed by Peyer (2002), as the author

finds that diversified firms with large and efficient ICMs use more external financing than other

companies. Additionally, smart money reflects the ability of the parent company to allocate

resources more correctly as they possess information that external markets will not. The

manager will have more knowledge of the various divisions and their prospects, which should

lead to better decisions via picking the better projects and engaging in better monitoring.

Furthermore, the parent company has a greater incentive to redeploy capital as it will be used

to maximise value whereas managers only care about their own divisional projects. The effect

of more money and smart money can be combined into one situation in our case. For example,

let us assume that Next controls multiple divisions including New Look. As mentioned earlier

Next owns all divisions’ assets and has the authority and desire to allocate resources

effectively. If Next, is convinced that New Look has positive net present value investments

then Next can use other divisions’ assets as collateral and raise resources only for New Look’s

investments. This means that the parent company is able to raise more resources by combining

various divisions’ assets (more money) and allocate all resources to the most profitable

investment (smart money). This would not be possible via the ECMs as firms would not be

able to combine assets to raise more capital and the bank has not got the authority to use other

firms’ rightful assets or resources to fund the most profitable investment.

Furthermore, according to Gertner, Scharfstein and Stein (1994), the use of ICMs leads to

better resource monitoring and more efficient reallocation of poorly performing assets within

projects. Better resource monitoring arises because the parent company has the authority over

divisions and directly monitors the flow of information between the capital providers and

divisions. The parent company’s value depends on a divisional performance basis and hence,

better monitoring is an incentive to maximise value. In addition, ICMs enable the efficient

redeployment of poorly performing assets. Headquarters owns multiple divisions and is able

29
to have a better high-level information regarding the divisions and their performance. This

allows headquarters to identify the inefficiently used resources or assets and redistribute them

to maximise value by injecting them into other profitable opportunities. This can be done only

via ICMs as the parent company owns the assets and has the authority to do so. In the case of

ECMs, capital providers do not have the authority to reallocate assets. As Stein (2003) clearly

explains, a bank will have to wait for the firm to default before acquiring the asset and then

selling it to redeploy any proceeds. The latter process leads to time and cost inefficiencies as it

takes time and the asset could be sold below market value when the firm defaults. Before

default, the external capital providers can only suggest solutions whereas a parent company

can proceed with restructuring when desirable.

In addition, Berger and Ofek (1995) explain, that possible advantages include lower taxes,

improved debt capacity, greater operating efficiency and fewer incentives to not fund value-

enhancing projects. This complements the winner picking method mentioned by Stein (1997)

where the good projects receive resources that might not have in case of a standalone firm.

Lastly, Hovakimian (2009) and Shin and Stulz (1998), state that a major ICMs benefit is the

fact that good projects are protected from external financing inefficiencies. In other words,

ICMs make it more likely for good projects to receive funds in comparison to ECMs as they

avoid problems such as adverse selection and moral hazard.

On the other hand, literature coming from the 1990s highlights that diversified companies are

discounted by the markets which suggests that benefits are cancelled out.

3.2 Drawbacks of internal capital markets

Berger and Ofek (1995), highlight that ICMs have a number of disadvantages including,

misalignment of incentives, misallocation of resources and managerial discretion over

allocated resources which contribute towards their inefficiencies. It is not always true that

30
ICMs allocate resources effectively, but instead, they can misallocate resources and hence

destroy firm’s value. Destroying firm’s value can be the result of overinvestment, the

interdependence of projects and wrongly ranked projects. As we mentioned earlier ICMs are

beneficial in the case of underinvestment in a firm due to the more money effect. On the other

hand, as Hovakimian (2009) argues, this effect may turn into a disadvantage if the firm invests

the resources into poor projects instead of the good ones. Thus, the more money effect can be

disadvantageous if funds are misallocated. Berger and Ofek (1995) associate the

overinvestment and cross-subsidisation with diversified firms, which destroys value when

compared with stand-alone businesses.

Furthermore, a study conducted by Lamont (1997) analyses non-oil segments within major

United States of America (US) oil companies during the oil price decrease of 1986. The study

indicates that cash/collateral reduction in the oil industry reduced investments in the non-oil

segments of the diversified firm and the diversified business segments dependent on each other.

The author gives a clear example of Chevron Corporation where the oil price reduction led to

the reduction of spending in refining and marketing, oil and gas pipeline, minerals chemicals

and shipping operations. On the other hand, stand-alone petrochemical focused firms increased

their investments during that period. Lamont (1997) concludes that ICMs are not efficient

because large cash flow decreases in the oil segments affected the investments in the non-oil

segments. That should not be the case if the investment prospects remain the same in the non-

oil divisions. In other words, a possible cost arising from ICMs is the propagation of shocks

affecting one division to the rest of the group. The author provides further evidence that is

consistent with the subsidisation of underperforming segments indicating that resources are

misallocated.

Furthermore, Shin and Stulz (1998) explain that ICMs fail to allocate resources to the best

investment projects and as a result diversification is costly. Even though ICMs are active, their

31
role is not significant. As Lamont (1997) states, segments depend on other segments’ cash

flows, but they are significantly depended on their own division’s cash flow as well.

Furthermore, as we mentioned earlier allocation of resources should be allocated depending on

the profitability of the project, however, that is not always the case. Shin and Stulz (1998)

expect that resources will be allocated to the most profitable projects and not significantly

affected by other divisions’ performance. On the other hand, their results show that the cash

flow of the division with the best projects has the same sensitivity to the cash flows of other

segments (with less favourable projects). This shows that ICMs do not necessarily protect the

good investments from adverse shocks, which suggest that they are inefficient.

In addition, literature explains that misalignment of incentives amongst the manager and

divisional managers or shareholders is a drawback and can explain ICMs inefficiencies. Shin

and Stulz (1998) argue that if managers take actions to pursue their personal objectives over

the parent company’s goals they might end up using the ICM to fund poor or negative net

present value projects. The authors conclude that the divisional managers that benefit the most

from the reallocation of resources are the divisions which are less profitable. Furthermore,

Stein (2003) states that misalignment of incentives can be the result of when the manager is

focused on building an empire, choosing projects that will require its expertise and generally,

have a shorter-term vision. This becomes even more interesting when managers are enjoying

private benefits from their role. Their goal might be to preserve the business from defaulting

hence, building an empire and diversify, as well as engage into short-term actions that will

indicate superior performance safeguarding its role. These actions are diverging from

prioritising the company’s value and ICMs can play a significant role in helping the manager

to do so. Furthermore, Rajan, Servaes and Zingales (2000) analyse misalignment of incentives

examining diversified firm in the US for the period 1980 to 1993. Assumptions in their model

include, that the diversified firm has two divisions, the parent company has limited power over

32
those divisions and lastly, resource allocation is achieved through negotiations. As soon as the

funds are allocated, the divisional managers can choose to invest in efficient (more optimal

decision for the firm) or defensive projects. The diversification of resources and investment

opportunities decrease the incentives for divisional managers to undertake the efficient project,

which in turn indicates that ICMs can allocate resources differently and in this case leads to an

inefficient way. Lastly, this supports Gertner, Scharfstein and Stein’s (1994) argument that

ICMs can lead to reduced managerial incentives.

3.3 New Look acquisition and internal capital markets value

To sum up, literature explores both views that diversification creates and destroys value. When

inefficient they destroy however, when efficient they add value. Concluding if a group gains

or loses value as a result of ICMs is a challenging task. However, in the following section we

examine several case studies where we try to understand if the acquisition of New Look will

make ICMs more efficient or not. In other words, will the New Look acquisition add or destroy

value?

3.3.1 Case study Chilean Groups 1990 - 2009

Buchuk et al. (2014) collect data for Chilean groups from 1990 to 2009 and examine tunnelling

(decisions taken by corporation benefiting the majority shareholders by concentrating funds)

and financial advantage (the avoidance of friction such as asymmetric information and agency

problems with external financing) theories.

The results of this study find that the evidence is inconclusive in supporting the tunnelling

theory. Instead, the authors find that close lending relationships are created between firms that

have similar business sectors. In addition, evidence suggests that on average financial

advantage exists amongst the Chilean business groups. Funds are transferred to smaller,

33
capital-intensive firms and this enables the firms to increase investments and return on equity

(ROE) whilst reducing their external leverage.

The conclusions of this case study can be applied to our case. Firstly, as mentioned earlier,

there is inconclusive evidence for tunnelling which means that majority shareholders do not

exercise their authority to transfer funds where they will benefit the most. Substituting these

shareholders with the CEO we may argue that in the presence of ICMs the CEO might not

necessarily exercise its authority to benefit from it, but instead put the firm’s/shareholders’

value first. Secondly, the fact that funds are transferred between firms indicate that ICMs are

active. In this case study, ICMs allow firms to avoid external capital frictions which will be the

case in an ICM with Next and New Look. The receivers in the case study are able to increase

their investments and ROE whilst they decrease external leverage as external capital is costlier.

Similarly, we can apply this in our case as ICMs are expected to be active and funds will be

distributed towards investment opportunities and at the same time will cost less when compared

to external funds.

3.3.2 Case study Indian Business Groups 1989 – 2001

In this study, Gopalan, Nanda and Seru (2007) investigate Indian Business Groups’ intra group

flows for the period 1989 to 2001. To start with, the authors find that intra group loans, similar

to ICMs, are significantly active. The motives of using ICMs as explained by the authors are

to finance new profitable projects by avoiding costly external capital, support weaker firms

within the groups and raise additional resources from the ECM by tunnelling cash out of firms

with low insider holdings into firms with high insider holdings. The authors provide evidence

that groups extent loans to financially weak firms and extend the loans’ duration if required.

The reasons for doing so as mentioned in the study include avoiding bankruptcy and negative

information for the group as a whole which can have negative spill overs on other firms.

However, there is no evidence that these resources are transferred to capitalise on new

34
investment opportunities as the receivers of the loans perform poorly in terms of stock return

and operating performance. In addition, there is little evidence to support tunnelling as there is

no increase in the cash outflow from low insider ownership firms when they experience a

positive earnings shock. Their analysis also provides evidence that intra group loans are

provided at a 10 percent below market rate on average and based on more flexible conditions.

Furthermore, the study indicates that the probability of default for groups is significantly lower

than for standalone firms. However, they also mention that when the first firm goes bankrupt

the rest of the group is significantly impacted beyond expectations.

This case study provides evidence that we can take in consideration regarding the Next and

New Look ICMs. Firstly, it is evident that ICMs benefit from the allocation of resources

internally as more funds can be raised and is less costly for the group. In addition, the transfer

of funds between the divisions reduces the bankruptcy probability for the whole group which,

could partially explain the reduction of costs in raising funds externally. This supports the

evidence, provided by Hovakimian (2009), that during recessions ICMs can add value to firms

as groups have reduced probability of bankruptcy. On the other hand, this study clearly states

that the allocation of resources does not depend on the profitability of the projects but, in

general, depend on supporting weaker firms. This indicates that ICMs are inefficient however,

that is the case when the group indeed has weak divisions. Lastly, the fact that the group has a

lower probability of default during normal times turns to a disadvantage when a division goes

bankrupt. As expected the group will be affected by negative spill overs of a division’s

bankruptcy. Hence a careful examination of New Look financial position will be crucial in

determining its financial health and viability.

3.3.3 Case study Korean Business Groups (chaebol firms)

Almeida, Kim and Kim (2015) examine the capital reallocation, investment and performance

amongst Korean business groups (chaebol firms) in the aftermath of 1997 Asian crisis. The

35
authors conclude that chaebol firms transferred resources from low growth to high growth

firms using ICMs. This allowed them to invest more in comparison to their control group and

achieve higher profitability which led to less decrease in valuations than the control groups.

They explain that the wider financially stressed environment led to costly external financing,

which enhanced the importance of ICMs within chaebol firms. As the authors argue, the

relationship between growth opportunities and investment becomes stronger amongst chaebol

than control firms. This is because, chaebol firms with industry level Tobin’s Q above the

chaebol median do not show significant declines in investment after the crisis. At the same

time, chaebol firms with low growth opportunities experience a significant decline. On the

other hand, control firms experienced a large and negative investment effect no matter if they

belonged in high or low Tobin’s Q groups. This contradicts, Lamont’s (1997) study as

Almeida, Kim and Kim (2015) indicate that ICMs protected the divisions with high growth

opportunities as chaebol firms engaged in winner picking and reallocated resources to more

prosperous firms.

In regard to our case, this study clearly indicates that during a crisis ICMs are creating value

for groups or in other words, destroy less value than companies that do not have ICMs. As

Hovakimian (2009) highlights that this might indeed be the case during recessions. The author

continues to explain that during financial constraints limits the ability of a firm to finance all

positive net present value, however, it the shock enhances the quality of the projects that have

been chosen. This implies that even though the fixed pool of resources is decreased the

managers are able to use that pool more effectively by allocating them to the most valuable

projects. Kuppuswamy and Villalonga (2010) analyse the value of firms during the 2008

financial crisis and find evidence to support this idea. Next and New Look are strong players

within the UK economy, however, they have access to other markets internationally. The fact

that the UK economy and prospects are not optimal at this moment due to factors such as

36
Brexit, means that the acquisition of New Look might help Next to overcome the medium-term

challenges that are going to be faced by UK’s future. The acquisition can be advantageous for

both companies because they will increase their market power, reduce UK costs and increase

international bargaining power through operational synergies. These actions can create

resources that can be channelled through ICMs. The ICMs can potentially mitigate any

negative adverse shocks that the UK economy may face due to winner picking methods,

protection of profitable investments and potentially superior performance over standalone

firms.

3.3.4 Case study conglomerates and industry distress

Gopalan and Xie (2008) use periods of economic distress in industries as a natural experiment

to study the functioning of conglomerates’ ICMs. After they classify economic distress they

find 48 episodes between the period 1984 to 2002. The data used is collected from Center of

Research in Security Prices and Compustat and they compare both the performance and value

of conglomerates against single segment firms in distressed industries. Their results show that

conglomerates have higher sales growth, greater research and development (R&D) expenditure

and higher cash flows during the distressed periods compared to standalone firms. In addition,

they find that the valuation discount for conglomerates in comparison to standalone firms

decreases when one of the conglomerates’ segments is in distress. Lastly, their evidence

supports the financial constraint hypothesis and show that conglomerates are better off during

periods of distress due to ICMs.

This case study reiterates what we mentioned earlier in the case study on chaebol firms where

groups gain value or lose less value due to ICMs. The major takeover of this case study is the

fact that conglomerates are able to avoid external financial constraints during periods of

economic distress due to ICMs. Hence, Next and New Look are likely to have a reduced

valuation discount if faced with economic distress. As mentioned earlier the UK economic

37
outlook is not considered to be optimal and hence, the acquisition of New Look will probably

increase the efficiency of the ICMs. Here it is worth mentioning that the authors’ classification

of economic distress is a much more probable event than recessionary periods. In their

examined time period of 1984 to 2002, they found 48 episodes of economic distress and the

years 1989, 1990 to 1991 and 2002 are considered to be periods of recession. Hence, this

implies that it is likely that IMCs will add value more often than the frequency of recessionary

periods, highlighting their importance.

3.4 Interim summary

Acknowledging that there are multiple studies and case studies that we can consider in the

wider literature and that case studies have major differences with Next and New Look case, we

conclude that the acquisition of New Look can improve the efficiency of Next’s ICM. There is

mixed evidence regarding the correct reallocation of resources, managerial motives and

incentives, however, acquiring a similar nature business during today’s uncertain UK

environment has significant advantages. Firstly, the UK economic outlooks do not seem ideal

for the near future due to various risks, with the most important one being Brexit. As we

explained earlier ICMs are able to add value to groups during periods of recessions or generally

when external markets are distressed. New Look operates internationally and is a big UK

fashion retailer and that means that the resource pool for the group will expand and capture

international cash flows as well. Secondly, as Stein (1997) explains resources within ICMs are

allocated based on relative comparisons. In other words, funds are allocated to most profitable

projects. Even though the evidence provided by the case studies and literature is inconclusive

if that is true we believe that the fact that Next has the expertise in fashion retail already will

help make ICMs more efficient. In other words, the fact that Next will acquire a firm in a

familiar business area will lead to more effective smart allocation or winner picking projects

38
as they have the expertise to do so. Thus, we conclude that the acquisition of New Look has

the potential to improve the ICMs’ efficiency.

4 Next’s corporate governance and ownership structure

The term corporate governance is derived from an equivalence between the government of

countries, cities or states and the corporations’ governance (Becht, Bolton and Roell, 2003).

This term was extensively used throughout the economic and political changes started in the

Organisation for Economic Co-operation and Development countries from the mid-1980s

(L’Huillier, 2014). Denis and McConnell (2003) define corporate governance as a system of

mechanisms (both market-based and institutional) that encourages the controllers of a

corporation to make decisions which increase the value of the corporation to its owners.

L’Huillier (2014) further argues that corporate governance is aimed to create and monitor the

mechanisms that are set by the shareholders to control corporate insiders to maximise their

wealth by reducing agency costs. Brown and Caylor (2004) suggest that well-governed

companies will have better operating performance.

4.1 UK corporate governance code

Next is a UK-based company and, therefore, the board of directors complies with the 2014 UK

Corporate Governance Code (the Code), which is the version of the Code that applies to the

latest published financial year (Next, 2017). The Code provides a framework of good practice

with regards to a company’s board of directors’ composition, board effectiveness, the role of

board committees, risk management, remunerations, and relations with shareholders (FRC,

2017). Its purpose is to provide effective and entrepreneurial management that can bring long-

term success to the company (FRC, 2016). The Code operates on the principle of comply or

explain. Listed companies must comply with the Code under the Financial Conduct Authority

(FCA) Listing Rules. If the company does not comply with the provisions of the Code during

39
the financial year, they must provide an explanation for the reasons they did not (FRC, 2010).

As FRC (2017) underlines, if the shareholders are not happy with the explanations, they can

use their rights (the power to appoint and remove directors) to hold the company accountable.

Within the annual reports of Next, it is stated that the company complied throughout the years

under the review with the provisions set out in the Code.

4.2 Board structure and directors of Next

According to Adams, Hermalin and Weisbach (2010), corporate governance and the board of

directors are matters of fundamental importance in the function and effectiveness of a

company. This can be easily observed in the cases of big companies over the past years, such

as Enron Corporation, MCI Incorporation and Parmalat Società per Azioni, where amongst

other factors, their board of directors was not functioning properly (Adams, Hermalin and

Weisbach, 2010). The board of directors is charged with numerous responsibilities that include

the monitoring of management to protect shareholders’ wealth and interests (Xie, Davidson

and DaDalt, 2003). These duties include hiring the management team and dismissing the

executives when necessary, evaluating important investments and acquisitions and others.

Therefore, a company needs an effective and well-functioning board to achieve high

performance and satisfy the shareholders. The UK Corporate Governance Code recommends

that the chairman and the CEO of a corporation have to be separate individuals (FRC, 2016).

The Code also suggests that the board composition has to be diverse, meaning that the board

must consist of non-executive directors as well, not only executive ones. According to Adams,

Hermalin and Wiesbach (2010), directors can be divided into two groups: inside and outside

directors. Usually, an inside director is called when he or she is a full-time employee of the

company whereas an outside director is the one whose primary employment is not with the

company. Moreover, outside directors are often considered as independent directors and an

40
outside director of one company may be the CEO of another. Hopt and Leyens (2004) explain

that an independent non-executive director is vital for the company because he or she is not

involved in the running of the day-to-day business of the company and it may reduce the

conflicts of interest of the shareholders. They further state that a balanced structure of the board

should include at least half of the total number of independent non-executive directors,

excluding the chairman. The above is some of the recommendations stated in the Code towards

an effective and efficient board of directors which leads to high corporate governance.

As far as our company is concerned, Next includes in their financial report the composition of

their board of directors under the section of corporate governance. To start with, the chairman’s

introduction comes first presenting his roles, which are to manage the board, ensure it operates

effectively and contains the right balance of skills and experience and, lastly, to promote a

healthy culture of challenge and scrutiny (Next, 2017). In the report, there are also underlined

the primary responsibilities of the board. More explicitly, the board is collectively responsible

for monitoring financial performance together with setting and monitoring Next’s risk

framework and risk appetite. As it is publicly accessible, the board of directors of our company

currently consists of four independent non-executive directors, four executive directors -

including the CEO – and the chairman (Next, 2018). The following part of the annual report

presents the compliance of Next with the Code. As we mentioned above, the Code recommends

that the roles of chairman and CEO must be occupied by two different individuals with different

responsibilities and duties. Indeed, that is the case with Next and the CEO is responsible for

the company’s system risk of management and internal control and for monitoring

implementation of its policies. Next’s CEO is a highly experienced individual as he has been

in this position since 2001. Furthermore, Next continually assesses and refreshes the board to

ensure they maintain the right balance of skills and experience. The current non-executive

directors are independent in character and judgment, and their knowledge, experience and other

41
business interests enable them to contribute substantially to the purpose of the board. The

senior independent non-executive director leads the evaluation of the performance of the

chairman through discussions with all the directors individually and, along with the chairman,

evaluates the performance of the CEO as well. All the skills and attributes of Next’s directors

are detailed within the annual report of the company and this provides the shareholders with

the information they need to know for the functioning and operations of the company. Taking

the above into consideration, all the appointed directors of Next are experienced and have the

appropriate skills to manage the company and proceed with the acquisition of New Look.

4.3 Next’s ownership structure

Demsetz (1983) describes the term ownership structure of a company as “an endogenous

outcome of a maximising process in which more is at stake than just accommodating to the

shirking problem” (p. 377). Looking back in history, the separation of ownership and control

in the modern corporation system was a matter discussed extensively by Berle and Means in

the year 1932. According to Demsetz (1983), economic theory and structure of a corporation

remain a central position in the literature. Bonazzi and Islam (2007) underline that the

separation of ownership and control is what characterises the existence of a corporation. As it

was mentioned above the directors of a company are trusted to act in the best interest of

shareholders who own the company. More specifically, Bonazzi and Islam (2007) state that

within a corporation the shareholders are called the principals and the managers the agents

working for the interests of the principals. Therefore, managers’ main duty is to protect the

interests of shareholders. Yet, their interests do not always perfectly align with the

shareholders’ (Adams, Hermalin and Weisbach, 2010).

With regards to our case study, Next offers their shares to the general public and can be

acquired by anyone. The company encourages its directors, managers and employees to buy

42
shares of the company through the share schemes developed. The company, in order to

encourage larger employee share ownership, operates the save as you earn share scheme in the

UK and Ireland, in which all employees are eligible to participate. Under this scheme, Next

gives the opportunity to its employees to express their views and ideas in the same way as other

shareholders. Consequently, this means that management’s interests will be more aligned with

those of shareholders.

Additionally, within the annual reports of Next, there is a section in which the major

shareholders of the company are shown (Next, 2017). More explicitly, at the financial year end

on 28 January 2017, Next had 147,056,562 shares in issue, which remained the same as on 22

March 2017. The three major shareholders of Next are Fidelity Investments Incorporated with

13.25 percent of voting rights, BlackRock Incorporated with 10.51 percent and Invesco

Limited with 5.12 percent of the voting rights. It is also underlined that voting rights are based

on the total issued share capital on 28 January 2017. Another shareholder of the company

(fourth shareholder in voting rights inside the company) is the Next Employee Share

Ownership Trust with 3.02 percent. The above top three of Next’s shareholders are institutional

investors. Because these investors own a considerable portion of Next’s shares, they can

influence the functioning and decisions of the management. If these major shareholders are not

pleased with the corporate governance and control of the company, they can exercise their

rights and ask for reform of the board of directors.

To sum up, in our opinion, there are two main approaches to whether the shareholders of Next

are likely to accept or oppose the acquisition of New Look. First, since they are the ones who

hired the board of directors, they can rely on their managers’ decisions for potential deals. As

we mentioned before, Next has high corporate governance and this means that the board of

directors is efficient and is aimed to maximise shareholders’ wealth. Lastly, Harford and

Kolasinski (2012) examined various buyouts in the US from 1993 to 2001 and they discovered

43
that stock prices increase when the acquirer announces the acquisition. Therefore, the share

price will be increased and this will satisfy the shareholders, and in turn, they can proceed to

acquire New Look. A deeper examination of the impact of the acquisition on the share price is

provided in section 5.2.

4.4 Effect on Next’s internal capital market

As Sautner and Villalonga (2010) state, there are very few empirical studies in the literature

that have investigated the actual link between ownership structure, corporate governance and

ICMs. To start with, due to the efficient and effective board of directors of Next, high corporate

governance can be achieved as the Code recommends. Corporate governance seeks to monitor

and create the mechanisms to control the corporate managers to maximise shareholders’ wealth

by reducing the agency costs (L’Huillier, 2014). Therefore, a company that possesses high

corporate governance might have fewer agency costs. Sautner and Villalonga (2010) conclude

that a company will not have efficient markets if there are high agency costs. After conducting

a natural experiment facilitated by a change in tax law in Germany, they further conclude that

corporate governance and ownership concentration play a crucial role in ICMs and how

efficient they can be. As far as the ownership structure of Next is concerned, we have

mentioned that three shareholders of Next occupy almost the 30 percent of the voting rights,

which can increase the probability of an efficient capital market (Sautner and Villalonga,

2010). Consequently, in our case, a higher level of ownership concentration leads to stronger

monitoring power and these major shareholders can decide the election of board members and

replacement of the CEO or poor management. Hence, this can reduce private benefits by the

executives, which increase ICM efficiency (Datta, D’Mello and Iskandar-Datta, 2009). Duchin

and Sosyuara (2013) also underline the importance of executives and managers in internal

capital markets. To conclude, it is worth mentioning the Sarbanes-Oxley Act in 2002, which

introduced some regulations and restrictions to enhance corporate governance and reduce the

44
probability of internal capital misallocation at the same time. Boumosleh et al. (2011) find that

this act has limited the misconduct of CEOs and enhances corporate governance. As the

literature suggests, in our case, Next has efficient and effective internal capital market, since

they have high corporate governance and high level of ownership concentration.

5 Acquisition of New Look

In this section, we examine the potential motives of Next for acquiring New Look as a PE

backed company and we are going to discuss what is the likely impact on the share price of

Next when this deal will be announced.

5.1 The private equity firm Brait

New Look is one of the biggest multichannel fashion retail brands in the UK. The company is

private since 2004, where Apax Partners Limited Liability Partnership (Apax Partners) and

Permira Advisers Limited Liability Partnership (Permira), two PE firms, bought them for GBP

200 million from the public (Achleitner et al., 2009). On 26 June 2015 Brait, another PE firm

bought New Look from Apax Partners and Permira for GBP 780 million (Nuttall, 2015). Brait

is a South African based PE investor company (Brait, 2018). According to Invest Europe

(2017), a PE deal is an equity investment into companies which are not listed on the stock

exchange and therefore are private. Usually, it is a medium to long-term investment where the

main advantage lies in active ownership as it improves businesses by providing management

expertise, enhancement of their operations and helping companies to grow.

In the case of New Look, Brait decided to invest in 2015 because, according to their

perspective, New Look was a business with a lot of potential due to their market position as

UK’s number one fashion retailer for women under the age of 35 and the potential to grow in

a number of geographic markets (Apax, 2015). While the firm was private under Apax Partners

and Permira, New Look grew significantly by increasing the number of stores from around 500

45
to 872, which resulted in increased revenue by 219 percent over the eleven-year period (New

Look, 2017; New Look, 2004; Fashiongear, 2018).

Today, after 14 years of being private, Brait may look for an exit strategy for New Look,

because as our analysis shows, there was no significant increase in the financial ratios of New

Look. It is rumoured that Next, a UK based fashion retailer, shows interest in an acquisition of

New Look from Brait.

5.2 Acquisition of New Look

This possible transaction from Next’s perspective is an acquisition. The mechanism refers to

the purchase of an asset, a division or even an entire company. In this process, there is a buyer,

in our case Next, who purchases the assets or shares from the seller by using different means

of payment such as cash, the securities of the buyer or other valuable assets from the seller’s

perspective (Sherman and Hart, 2005). For the acquisition of New Look, Next has to pay the

determined and agreed amount to Brait, the actual owner.

The acquisition amount can be determined by a variety of valuation models. One example is

the discounted cash flow (DCF) method, which is an income approach. All available future

cash flows will be discounted to time period zero with cash flow 𝐶𝐹, discount rate 𝑟 and period

𝑛 (Fernandez, 2017).

\
𝐶𝐹\
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = [
(1 + 𝑟)\
_`a

Formula 13: Discounted cash flow method

This approach has the requirement that all future cash flows are known until infinity. In reality,

such event is not possible. We can only estimate the future cash flows. For our calculation we

use the DCF perpetuity approach, where we assume the cash flows only grow by the growth

rate 𝑔. When 𝑛 goes until infinity, the formula becomes as presented below (Fernandez, 2017).

46
𝐶𝐹 × (1 + 𝑔)
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 =
𝑟−𝑔

Formula 14: Discounted cash flow method perpetuity

For New Look, we looked on the increase and decrease of the cash, cash equivalents and bank

overdrafts account of the last ten years from 2008 to 2017 and adjusted these values according

to Armitage (2008). We determined as an average cash flow 𝐶𝐹 GBP 2.4 million over these

ten years and assume a growth rate 𝑔 of 0.2 percent. The discount factor 𝑟 is 0.5 percent, as

published by Bank of England (2018). Through these information, we can calculate New

Look’s present value in the amount of approximately GBP 800 million.

Taking the above into consideration, Next has to pay GBP 800 million, as calculated, to Brait

for the acquisition of New Look. However, this is only a numerical company valuation with

the exclusion of other qualitative factors which we have to take into account (Martin, Petty and

Rich, 2003). Hence, depending on Brait’s New Look valuation, they can demand a higher or

lower price from Next. DCF method is only one of a few valuation approaches. Other methods

which could be used are valuation through market approach or valuation of the assets (Meitner,

2006; Rojo-Ramírez, 2014).

According to Sherman and Hart (2005), different companies have different motives in

acquiring a company. But generally, they include a desire to accelerate the growth of revenues

and cost savings through scale effects and by that increase their profits, improve the buyer’s

competitive position, widen existing product lines, and expand into new geographic markets

or segments as a result of a diversification strategy.

The acquisition of a competitor, even if the target firm is public or private, presents many

advantages and disadvantages. In our case, Next would make a strategic acquisition and, as

both companies operate in the same industry sector, the company is in an advantageous position

to estimate the true and fair value of a business better than any other types of buyers (Povaly,

47
2007). Furthermore, the author states the fact that strategic buyers have more bargaining power

compared to other buyers, which allows them to ask for and gain access to inside information

about the firm if the target firm is private. Moreover, Kent, Filbeck and Kiymaz (2015) state

that a strategic buyer may expect a greater competitive advantage and market share. According

to our specific case, the market for fashion retailers is worth around GBP 66 billion per year

but is very competitive (Fashionunited, 2018). Without the New Look acquisition, it would be

very hard for Next to expand in this market. Moreover, Next would acquire through this

acquisition an additional amount of 592 Stores in the UK and 280 international Stores which

can improve its competitive advantage (New Look, 2017). Stores, which are located next to

each other, of New Look and Next could be merged but operated separately as two brands.

Besides, there is the opportunity for Next to open up new geographical markets, specifically in

China. Taking into consideration UK’s decision to leave the European Union, the UK fashion

retail industry will face medium-term challenges. Hence, an international expansion by

acquiring New Look will be beneficial for Next as it will strengthen their international presence

(Daly, Hughes and Armstrong, 2017). Consequently, this acquisition would create a significant

value of synergy between the two companies which would be represented in an increase in

revenue and cost savings resulted from combining the two companies (DePamphilis, 2013).

Best practice examples are the Swedish multinational clothing retailer Hennes & Mauritz

Publikt Aktiebolag, which has six brands under one roof and the Spanish fashion group

Industria de Diseño Textil Sociedad Anónima, which is the biggest in the world with eight

brands (H&M, 2016; Inditex, 2016). One main part of the cost savings is the more efficient

purchase of the products from the producer by strengthening the purchasing power (Pazirandeh

and Herlin, 2014). This acquisition will possibly improve the supply chain’s efficiency through

scale effects in the distribution of the assets (Boon-itt, Wong and Wong, 2017). Furthermore,

Next can expand their business with the franchise segment of New Look and adapt further

48
revenue through franchising the brand Next as well. Another benefit of an acquisition is the

financial synergies as explained in chapter three of this report. All the rising synergies will end

up in an increase in revenue and decrease in cost for the new holding structure of Next and

New Look, in our opinion, which should be reflected in a higher share price.

The main drawback, in this case, is that a strategic buyer has to pay a premium for companies

due to the strategic fit and arisen synergies (Povaly, 2007). Considering that New Look is

owned by a PE firm means that management style and investors’ strategy differs.

The management incentives in a PE firm differ from the public company as their equity

holdings of stocks and options are much higher (Kaplan, 1989). Acharya et al. (2011) studied

66 large buyouts in the UK from the years 1996 to 2004. Their findings are that the median

chief executive officer (CEO) gets six percent of the equity while the median management

team as a whole gets 15 percent. Moreover, as the company is private, management cannot sell

its equity or exercise its options until the exit transaction is done. This restriction reduces

management’s incentive to focus on the short-term performance of companies, as argued by

Kaplan and Strömberg (2008). Therefore, New Look’s strategy should be sustainable over the

long-term, which should be recognised by the market and consequently represented in an

increasing share price.

Furthermore, due to the leverage, managers face the pressure not to waste money because they

have to generate enough cash to cover the debt (Kaplan and Strömberg, 2008). Moreover, based

on the research of Povaly (2007), some PE firms have some exit policies that require the

professionals to exit after a certain target holding period which typically lasts three to five

years. Brait claims that they have a long-term strategy for all of their investments (Brait, 2018).

But as we can see from the financial analysis in chapter two, there was no significant change

in the financial numbers of New Look. This could be a reason for Brait to seek an earlier, than

expected, exit strategy to generate a small profit before it is maybe too late later on.

49
Another difference between PE investors and public companies is the governance of the

company, because the board of PE firm is smaller and more active compared to public

companies. In this case, Acharya et al. (2011) argue that PE investors usually have around nine

formal meetings per year, the same number as public companies, but they also have many more

informal meetings.

Once the PE firm acquires a company, the management team would be responsible for

increasing its value by cutting the expenses or searching for other opportunities. Kaplan’s

(1989) study shows that, on average, there is an increase in operating income of 24 percent

three years after the buyouts. In addition, there are also improvements in the ratios of operating

income to sales and net cash flow to sales which increase significantly, as well as a drop-in

capital expenditure but not in employment. Furthermore, Lichtenberg and Siegel (1990) found

a significant increase in total productivity after the buyout for leveraged buyouts. These

findings prove that PE investors do create a value for the company. But as we can see from the

financial analysis Brait did not really increase the value of New Look since 2015.

Considering the stated factors, one should consider that this type of acquisition should be

assumed as a friendly takeover, because New Look is owned by a PE firm. This is due to the

fact that managers, as well as equity investors, would like to exit from the investment and at

the same time, Next is willing to buy New Look. Therefore, there should not be any kind of

defensive strategies that might have occurred if the company was public as it may happen in

the case of hostile takeovers. This can be translated into faster completion of the transaction.

As a result, Next does not have to fear defence mechanism from New Look, which makes the

acquisition less costly for Next, as argued by Field and Karpoff (2002).

One of the main disadvantages of acquiring a private company, as highlighted by Ghani (2011),

is the lack of transparency which may attribute to the fact that the target company believes that

the firm may lose its competitive advantage by disclosing information. Therefore, the acquirer

50
can be negatively affected by information asymmetry problem as the only source of

information is provided by the target firm’s owner. Furthermore, when private business owners

want to sell a business, they may manipulate the information provided by overstating the

revenues or understating the operating expenses (DePamphilis, 2013). Similarly, private firms

have fewer levels of control and reporting, in comparison to public companies, which results

in greater difficulty to examine the company’s past performance by the acquirer. Also, there

may be other firm-specific problems which would affect the valuation of the company as well

as its analysis (Sherman and Hart, 2005).

Moeller, Schlingemann and Stulz (2004) examined 12,023 acquisitions by public firms from

1980 to 2001. They contradict previous statements that the equally weighted abnormal

announcement return is 1.1 percent, but acquiring-firm shareholders lose on average upon

announcement. They also researched that the announcement return for acquiring-firm

shareholders is two percentage points higher if the acquired firm is private.

5.3 Interim summary

To sum up, the advantages of acquiring a private company backed by PE firm are significant.

Existing research highlights that the share price either rise or drop after the announcement of

an acquisition. It depends on each case. Considering the research of Harford and Kolasinski

(2012), where 788 large US buyouts where analysed from the years 1993 to 2001, they have

found that strategic buyers’ stock prices increase proportionally to the transaction size when

the acquirer announce the purchase of a target company from PE investor, particularly if this

one is well governed. Furthermore, long-term focused strategic buyers generally can increase

their share price after the transaction is announced (Harford and Kolasinski, 2012). This

implies that strategic buyers benefit rather than being harmed by investors. Moreover, the same

authors proved that PE investors do not sacrifice long-term value for short-term profit. This

51
could be hard considering that Brait might have longer-term interests in their investment.

Otherwise, if the deal is announced, the share price is likely to increase because of the generated

synergies, from which Next will gain in the long-term. However, we need to mention that the

actual reaction cannot be predicted for sure, because stock markets are unpredictable, as stated

by Mailath, Postlewaite, and Samuelson (2004).

6 Costs and benefits of New Look as a standalone company

An additional option for Brait to exit its position on New Look is through an IPO. In this

section, we evaluate the consequences of New Look becoming a standalone company,

including both benefits and costs, which will involve a primary offering by selling the shares

of Brait to the public. As mentioned by Brealey, Myers and Allen (2010) IPOs are frequently

used to shareholders cash in by selling their part on the companies.

For a better understand of the implications of IPO and New Look becoming a standalone

company, it is important to analyse two crucial moments on the company’s life: the moment

before the acquisition by PE firm, when the company acted like a standalone company and the

present momentum of New Look.

Before the first acquisition by the PE firm Apax Partners in 2004, the company went through

some difficulties in the year of 2001 with a loss of roughly GBP 1 million at the end of the

year. Despite the fact the company continued by itself and after some internal restructuring, the

revenues increased, the company had profit and improved its indicators the years after. Despite

the improved results verified on the previous years, in 2004, the company had ambitious plans

of the company and due to the lack of confidence of the markets the company decided to go

private, approaching Apax Partners to complete the operation. This operation allowed New

Look to pursue their plans for expansion and growth, which as a standalone company would

be very difficult. As part of Apax strategy as a PE firm, in 2007 the company started to look

52
for an exit and in 2015 the operation was finalised by the selling of New Look to a new PE

company, Brait. This brings us to the present moment of the company where after the latest

acquisition the company has reported two years of consecutive loss, 2016 and 2017. According

to these two annual reports, the results are due to two major costs on the accounts: the

administrative and finance expenses. The increasing amount of administrative expenses over

the last two years are possibly due to a missing strategy of Brait for New Look which might be

caused by their lack of know-how in the fashion retail industry. On the other hand, it is clear

the improvement brought by Brait on the finance expenses which allowed New Look to reduce

in almost half this type of costs. This indicates that the new company had a positive impact to

the way New Look has been financing and also shows that choosing to become standalone can

be challenging and during a recovering period may be very harmful to New Look. In the

following section we will discuss potential benefits and costs of a standalone firm.

6.1 Benefits of a standalone company

The aim of an IPO is to turn the company public by raising funds as explained before. Going

public will make the company more exposed to the market agents which will increase its

reputation among the other agents acting in the markets. As stated by Ewelt-Knauer, Knauer

and Thielemann (2014), an operation like IPO, due to its press coverage, will be seen as a more

prestige step than a merger and acquisition (M&A). This means that a full successful IPO will

increase the reputation of the company on the markets. Rosen, Smart and Zutter (2005)

highlight that after going public, a company becomes a target and is under surveillance of more

companies in the market and its peers. The increasing attention under the public companies

and the good performance of New Look may increase its prestige and be a major player among

its peers.

53
Additionally, Ernst & Young (2013) points out that being a standalone firm means that the firm

has access to market funds more easily. One of the advantages of this situation is the possibility

of New Look issuing more shares without relying on Brait, Next or another PE firm. Pagano,

Panetta, and Zingales (1998) explain that a benefit of going public is the fact that a public

company can overcome borrowing constraints. For companies like New Look with high

leverage it might be favourable to be public as a way to attract new investors and alternative

sources of financing. Dambra, Gustafso, and Pisciotta (2018) affirm that a large amount of

IPO issuers (around 35 percent) raises more money two years after the operation, which is

called the seasoned equity offering. Considering this option, New Look could gather more

money by issuing shares itself.

Moreover, managers of the companies may find more attractive the fact of being a standalone

company because they can keep the control of the company which does not happen when a

company is taken by another company (Povaly, 2007). As a result, according to Ernst & Young

(2013), a standalone company facilitates future acquisitions of other businesses. On a survey

conducted by Brau and Fawcett (2006), the number one reason for chief financial officers to

go public was to facilitate future acquisitions, which would allow shares to become an

acquisition currency. There is evidence that the easiness to access the markets and obtain

capital to finance future acquisitions are the main reason for a company to pursue some M&A

operations after an IPO (Celikyurt, Sevilir and Shivdasani, 2010).

6.2 Costs of a standalone company

There are several costs and risks for New Look to become a standalone company. The first risk

resulting from the IPO operation would be a damage on the reputation of the firm due to a bad

outcome and acceptance from the markets. According to Povaly (2007), there is a risk of

54
reputational damage if the IPO is not seen as a success. As a result, the company can see its

condition with its commercial partners deteriorate.

If one of the benefits of acting as a standalone company is the easiness of access to the markets

and financing, it is also true that the financing through the markets includes the payment of

interests, which will increase the financial costs of the company. As we have stated in section

three, ICMs enable cheaper financing compared to standalone firms. On the long term, this

situation can be very problematic for the future of the company because the increasing payment

of interests will lead to unfavourable debt position. In section two, where we examine New

Look’s financial performance, it is evident that the company is not in a favourable position to

deal with an increased interest payment due to low-interest cover. Additionally, Brau, Francis

and Kohers (2003) confirm that despite the fact that being public brings the company closer to

funds providers, being a standalone company is not clear to be the best way to get funds from

the markets.

One of the challenges of going public to the companies is to maintain a solid strategy for the

future, respecting its values and ethics, and at the same time starting to present solid results to

the shareholders and all the other stakeholders. Povaly (2007) explains that the pressure arising

from investors to perform well in the short to medium-term makes it harder for management

to pursue strategic objectives. IPO can lead to short-term striving goals, altering the previous

long-term management focus. Povaly (2007) further underlines that short-term

underperformance may influence the stock price which will have a negative impact on the

reputation of the company amongst shareholders. Ghonyan (2017) affirms that as a standalone

company, it will be more exposed to internal and external pressure to maintain growth rates.

The unwanted results may prompt stockholders to sell their shares and as a result, it will drive

the stock price down.

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Johnson (2015) studied the effects of IPO on company’s innovation. The author concludes that

a consequence of an IPO operation leads to stagnation or decrease in innovation. Despite the

fact that the firm has more access to funds to finance its R&D projects, it is clear that it does

not happen. The author states that the main cause is the pressure from the investors to short-

term results which leads to dropping the investment in long-term projects that have no impact

on the current situation of the company. As a consequence, the company will look to invest in

fast-return projects as a way to impress the current investors and attract more in the future.

Kuppuswamy and Villalonga (2010) also find evidence that during the period of crisis, money

providers, like banks and bondholders, may prefer to lend money to conglomerates than

standalone firms. During these periods, credit becomes more rationed and standalone firms will

have more difficulties to perform well when compared with groups of companies. This leads

to an increase in value for these groups of companies when compared with standalone entities.

Additionally, any benefits arising from synergies are forgone. Given that New Look has high

administrative costs and gearing means that they will forgo the opportunity to find solutions

from an experienced company, such as Next. Consequently, the uncertainty period of Brexit

and the major challenges briefly mentioned in the sections before can be more harmful to New

Look as a standalone company.

Finally, Ghonyan (2017) states that another disadvantage of becoming a standalone company

is the amount of information to be disclosed. After an IPO, the amount of information

disclosure becomes much higher which increases the exposure of the company to competitors,

customers, employees and others, but also will increase the costs of producing that information.

6.3 Interim summary

An IPO is broadly considered a way of gathering money from the markets that can bring both

prestige and greater access to market funds. It is also important to take into consideration the

56
momentum of New Look to understand if being a standalone firm is the best option at this

moment.

To conclude, according to the current situation of the company, we identify more potential

costs than benefits, when operating as a standalone firm. What stands out from our financial

analysis is that New Look has high debt and financial costs and as a result, an IPO will be

damaging for the company. Hence, if New Look becomes a standalone firm, it might damage

both its image and financial structure.

7 Recommendations

7.1 Maximising limited partners return

Based on Invest Europe (2017), PE firms invest in companies that are not listed on the stock

exchange. PE firms usually have a medium to a long-term investment strategy that enables

them to acquire a firm and through active ownership enable the acquired firm to increase its

value. PE firms’ profit or investment return is an annual management fee of usually around one

to two percent of capital commitment and a 20 percent share of profits during exit strategy. In

other words, the main profit that Brait will make is based on New Look’s exit deal. As Kaplan

and Strömberg (2008) state the 20 percent share of profits is the main source of return for the

PE firms. In the following section, we will analyse what the best exit strategy is to maximise

return and profits for the LPs. In other words, which exit strategy is going to generate the more

money? The main exit strategies include IPOs, trade sales and secondary buyouts.

7.1.1 Initial public offerings

As Berk and DeMarzo (2014) clearly state an IPO is a process where shares are offered to the

public for the first time. This can be done by a primary offering, where new shares are sold to

raise additional equity capital, a secondary offering where existing shares are sold or a

57
combination of the two (Berk and DeManzo, 2014). For an IPO exit, Brait would have to sell

its shares and possibly combine this with a primary offering. On the other hand, Hoque and

Lasfer (2009) explain that this process usually comes with the fact that investment banks

require the PE firm not to sell a large proportion of its shares until after a lock-up period passes.

For the UK the lock-up period is 365 days on average.

Thus, it is difficult to determine the exact amount and time period of Brait’s return through an

IPO. Wall and Smith (1997) explain that IPOs are dependent on two factors. Firstly, the initial

offer price for the IPO and secondly, the market price at the time after the lock-up period. The

proceeds that will arise from an IPO after taking into consideration the two points above will

include both direct and indirect costs. Berk and DeMarzo (2014) highlight that direct costs

include, investment bank costs, inter alia, professional advisers’ costs and the costs associated

with listing the company on the exchange. In addition, Brealey, Myers and Allen (2010)

explain that a frequent and significant indirect cost is underpricing. We note that underpricing

is when the offering price is less than the market price at the end of the first day of trading.

Hence, Brait will most probably lose out on money as they could have demanded a higher price

per share given the observed common underpricing effect in IPOs. Furthermore, according to

Wall and Smith (1997), the proportion of shares withheld in the lock-up period is around 80 to

90 percent of the initial investment. Thus, the payoff will significantly depend on the share

price after the lock-up period. The lock-up period gives Brait the chance to actively help New

Look to perform well to maintain or push New Look’s share price higher. At the same time

there is significant exposure to risk as in one-year share price may well decline. The lock-up

period entails uncertainty and delayed effective exit.

On the other hand, we need to acknowledge the perception that proceeds from IPOs are

expected to be higher than other exit deals (Povaly, 2007; Poulsen and Stegemoller, 2008;

Bayar and Chemmanur, 2012), but at the same time realise that this will depend on market

58
sentiment and situation (Wall and Smith, 1997; Pagano, Panetta and Zingales, 1998).This is

because the IPO market is characterised by two distinct periods. As Helwege and Liage (2004)

explain, hot markets is the period of when a large number of issues are being made and cold

markets when few issues take place. As expected, firms prefer hot markets for IPOs and bullish

stock markets so that company valuations are higher and investors are more willing to purchase

IPO stocks, which can have a significant impact on the success of an IPO (Povaly, 2007). From

data that we have gathered from LSE (2018), it is clear that IPOs are fluctuating over time. The

graph below shows that the current IPOs are significantly lower than a number of time periods,

with the highlight being in 2006 and 2007; the years before the crisis. This suggests that the

IPO market is not particularly hot.

Graph 13: Number of IPOs and sum of money raised (LSE, 2018)

Other factors that may affect the decision or not to exit via an IPO include firm-level factors

such as, revenues and profitability, speed and complexity (listing requirements, due diligence,

and prospectus) of an IPO, certainty preference and reputational concerns.

7.1.2 Secondary buyouts

As Bonini (2014) states, “Secondary buyouts are leveraged buyouts in which both the buyer

and the seller are private equity firms” (p. 1). An exit strategy for Brait might be to sell New

59
Look to another PE firm. To start with, secondary buyouts (SBOs) have been historically

associated with distressed transactions as successful ones were perceived to be made through

IPOs or trade deals. On the other hand, Bonini (2014) clearly highlights that the trend has been

reversed after the recent financial crisis. The author further shows from the period 2012 to 2013

SBOs have accounted for over 60 percent of all deals. As Axelson, Strömberg, and Weisbach

(2009) explain, an SBO can be seen as an exit strategy if the seller is looking for a clean and

fast exit deal and return the capital to the LPs. Thus, an SBO can be seen as a quick return and

at the same time protect reputation. However, that does not contribute towards maximising the

returns to the LPs but instead might guarantee a timely return. An article on The Financial

Times (FT, 2017) highlights that the PE funding has reached pre-crisis levels which shows that

PE firms and their dry powder can provide a market for Brait. On the other hand, the literature

suggests that an SBO generally leads to a lower return in comparison with the first buyout

(Achleitner and Figge, 2014). Brait bought New Look from Apax and hence it is even harder

for another PE firm to generate a favourable return by acquiring New Look. In other words,

even if PE firms have the dry powder, it is likely that they will be looking for first buyout

opportunities instead of SBOs. If we consider that generating a return might be harder for the

new PE owner of the New Look, they will probably be less reluctant to offer a good deal to

Brait. Lastly, as the PE firm is a financial buyer it does not benefit from any synergies from

the acquisition and they may pay a lower price than a strategic buyer.

7.1.3 Trade sale to a strategic buyer

A trade sale to a strategic buyer is the sale of the company to another operating company, which

generally is a competitor (Povaly, 2007). In our case, this is the potential sale of New Look to

Next. This kind of deal is very similar to the financial buyer deal, however, there is a difference

in the buyer’s nature. This has some implication on the advantages and disadvantages when

compared with a financial buyer exit strategy.

60
Similarities between the two deals include a clean and relatively fast exit deal (faster than IPOs

but slower than financial buyer deal) as well as a potential market from interested fashion

retailers that might be attracted to the deal. Kaplan and Strömblerg (2008) highlight throughout

their study, from 1970 to 2007, the most common exit strategy, 38 percent of the time, was the

sale to a strategic buyer. This is because strategic buyers bring significant advantages to the

deal for the sellers. An important advantage for the strategic buyer is the fact that through the

acquisition they will benefit from synergies. In turn, after valuing the synergies the buyer will

be willing to offer a higher price to acquire the firm as they will benefit from synergies. Given

that the PE is aware of the valuation of the synergies they will try to absorb some of these

benefits by demanding a higher price. In our case, given that Next is already operating in the

particular industry and, as Povaly (2007) highlights, that strategic buyers have greater

bargaining power, Next will be able to demand inside information so as to estimate the true

value of the firm and synergies’ value. Hence, Brait will possibly be able to extract a proportion

of these synergies given that the interest of other competing firms might allow Brait to demand

a higher price form Next. Interestingly, Morkoetter and Wetzer (2015) examine 20,463 M&A

transactions and conclude that financial buyers pay less than strategic buyers due to their

expertise and relationships with financial advisers. The fact that PE firms are more active in

these deals helps them to build close relationships with the entities involved in deals, such as

investment banks and hence, are able to extract some value form these relationships. Hence,

this relative disadvantage of strategic buyers turns into an advantage for Brait as it is expected

that strategic buyers generally will offer a higher price.

7.1.4 Interim summary

As we have examined the various exit strategies that Brait can follow we conclude that the best

option is to pursue a trade sale. This is because we believe that the strategic buyers’ market

will offer a better price for such a deal as we have explained earlier with a significant factor

61
being potential synergies between the firms. Additionally, IPOs have the potential to provide

greater returns to the LPs but with great uncertainty and risks. There is an overdependence on

the market’s condition such as the current offer price and future New Look’s share price as it

is likely that there is going to be a lock-up period. Given the uncertainty of Brexit and the fact

that the stock market is considerably trading at high levels, we believe that the risks and costs

associated with an IPO outweigh the potential benefits. In other words, we believe that Brait

might suffer reputational damages and fail to realise the anticipated return from an IPO as the

recent examples of Debenhams Retail Public Limited Company and Sports Direct International

Public Limited Company poor IPOs’ performance showed in 2007.

7.2 Best interest of New Look

Taking all the previous sections into consideration, the best choice for New Look is to be

acquired by Next.

Starting with the financial analysis in section two, we found that New Look is not in the best

shape. More specifically, they have high debt, gearing and low interest cover. Additionally, the

firm has high administrative expenses and in general, it underperforms when compared with

the industry average. However, liquidity and efficiency ratios are better than the industry

average. This means that New Look can benefit and operate better when acquired by a strategic

buyer as they can take advantage of lower financing and administrative costs.

In the ICM section, section three, if Next acquires New Look, ICMs will enable cheaper

financing for New Look, which is a major advantage. Additionally, as Next has experience in

the UK fashion retail industry they will be able to evaluate the profitability of the projects more

effectively and hence, allocate resources efficiently. When compared with Brait, we believe

that Brait poses less experience in the UK fashion retail industry. Lastly, the fact that the UK

economy is uncertain due to Brexit negotiations New Look will be able to overcome medium-

62
term challenges when incorporated in a group than being standalone as we have stated in our

previous sections.

In section four which covers corporate governance and ownership structure, we have

highlighted that Next has high corporate governance and concentrated ownership, which leads

to efficient ICMs. In addition, the board of directors is experienced and has aligned interests

with their shareholders and as a result, this signals that they will try to generate value from

New Look. For example, they might be able to reduce administrative expenses due to their

prior experience. Furthermore, due to the fact that the current CEO has history of driving the

firm through the past crisis, it is likely that will guide the group to overcome any potential

challenges.

In the following section we underline that if New Look operates under Next, they will be able

to capitalise on synergies and increase their market share, which can reduce costs and increase

profits. Greater bargaining power on their suppliers might lead to lower cost of sales and more

efficient supply chain. In addition, New Look will have the chance to take advantage of well-

established Next’s niche sectors by sharing knowledge and expertise. Lastly, together as a

group their international expansion can be more successful and profitable. Such an expansion

will geographically diversify their cash flows and can mitigate any risks arising from Brexit.

Finally, evaluating the costs and benefits of New Look operating as a standalone firm, we

observed that the costs outweigh the benefits. More specifically, the high debt level and

financing costs will damage New Look if it decides to become a standalone company. Lastly,

one of the biggest benefits of going public is the generation of cash, however, in our case an

IPO will probably not lead to any benefits for New Look, as Brait will realise all proceeds. As

a result, we conclude that New Look will benefit the most from becoming Next’s subsidiary.

63
Appendices

Appendix 1 Consolidated income statement of New Look

64
Appendix 2 Consolidated balance sheet of New Look

65
Appendix 3 Financial ratios of New Look

Appendix 4 Financial ratios of industry average

Appendix 4.1 Marks and Spencer Public Limited Company

Appendix 4.2 Debenhams Retail Public Limited Company

66
Appendix 4.3 ASOS Public Limited Company

Appendix 4.4 Laura Ashley Public Limited Company

67
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