Maurizio Castello: Luxury's Pragmatist


Imran Amed | July 08, 2009

Imran Amed speaks to Maurizio Castello who warns that the Italian luxury industry is saddled with debt, leaving several companies at risk of shutting down.

Imran Amed speaks to Maurizio Castello who warns that the Italian luxury industry is saddled with debt, leaving several companies at risk of shutting down.

MONTE CARLO — At the Financial Times Business of Luxury summit held in Monaco in June, perhaps the most eye-opening and timely presentation came from Maurizio Castello, Head of KPMG Advisory fashion and luxury practice in Milan.

In a white paper published to coincide with his presentation, Castello writes: “Many luxury goods companies are in the grip of a double crisis. A declining economy has hit sales, while a financial credit crisis has made debt difficult to raise and service. The result is that many luxury companies find themselves in a liquidity crisis that requires urgent remedial action to survive.”

Several major “well-known names” from the world of Italian luxury are teetering on the edge of insolvency, according to Mr. Castello. Some of these troubled businesses are heavily burdened by debt that was used to finance rapid international expansion and product line extensions. Others are leveraged to the hilt, based on the debt-based financing strategies employed by major private equity firms.

In his white paper, Castello prescribes a four-point plan to address the financial distress, counselling luxury companies to adopt a liquidity mindset crucial to strategic decision-making.

His advice did not fall on deaf ears. Several attendees approached Mr. Castello after his presentation, saying this is exactly what they needed to hear. I caught up with him quickly so he could share the rationale of these dire predictions with the Luxury Society community.

IA: How did we arrive at this situation where, as you put it, several Italian luxury companies are teetering on the brink of insolvency?

There has been a vast amount of geographic and product expansion in the luxury industry in recent years, much of which has been financed by debt.

A number of private equity houses have invested considerable sums of money in luxury companies, using highly-leveraged capital structures to close the deals. One recent example was the investment in Valentino Fashion Group by Permira, which put in a huge amount of money to take a stake in the company at a very high valuation.

Brands without private equity investors have financed their own expansion by borrowing money directly from the banks.

Either way, today the situation is such that banks are placing more and more pressure to get their money back, as they grow increasingly worried about the ability of these companies to service their debt payments in a contracting economy.

IA: During your presentation you said that things can go very quickly from being financially distressed to going bankrupt. Do you expect, given the seriousness of the current situation, that some major luxury companies will become insolvent?

I’m not so sure that everybody will react in time to prevent that outcome.

What I have seen is that in the last few months, some companies have themselves come to understand that their financial situation is very difficult. They have pro-actively started conversations with their banks to renegotiate their debts or find some other solution, before it’s too late.

In other cases, the processes for financial control are not so strong and companies are unable to understand their real financial situation. Therefore, in these cases, it is the banks that are pushing and forcing the companies to provide more visibility of their cash flow and business outlook for the coming months as well as to renegotiate debt payments.

At the moment, we are witnessing both behaviours. In some cases we are asked by the company itself for help in getting out of this situation. But, other times it is the banks that call us to provide better comprehension of what is really going on.

Source: KPMG analysis of Bloomberg data; Morgan Stanley Composite Index

IA: Let’s focus in on some of the private equity deals for a moment. Is private equity going to continue to invest in luxury?

Generally speaking, I would say yes. There is no good reason to say no. That said, the luxury and fashion industry has its own rules that may be a little difficult for someone coming from outside the sector to understand..

For example, it may be difficult for a private equity house to get an immediate understanding of the rules, the process, or the calendars of fashion. There are aspects of the luxury industry which make it markedly different from other sectors and this can be a barrier to investment. But apart from that, in theory, there are no particular issues.

What I see is that, in the last few months, private equity investing has slowed down, or in some cases, has become totally blocked. [This is] because there is no liquidity or because there are no companies available for sale, which itself is in part due to the fact that prices are so low. Those who can afford to wait to sell, are waiting.

One thing is sure: private equity firms are being more selective. In the past, they were more focused on specific opportunities, not specific industries. If they found a potential deal that looked good in terms of return, they started the process of buying.

But what I am seeing now is that some private equity houses are changing their approach and are focusing on industries with the highest expected returns or growth rates over the next years.

From this point of view, the fashion and luxury sector is not on the target list. However, it must be said that this sector is much smaller than others, so it may just be its small scale which has kept luxury off the list.

IA: Since the credit markets are so tight and since private equity interest in the luxury sector may be slowing, where will luxury companies find access to capital in order to grow in the future?

Probably the first thing luxury companies can do is to find liquidity internally – from sales, from the reduction of costs, from lower working capital usage. This is where it will be much easier to find money that can be used for expansion in the medium-term.

There has also been a reduction in planned investment, wherever possible. For example, in terms of store openings, the strategy for luxury brands has been to finish what they have started and then to refocus the new store openings in a limited number of selected places.

The hope is that if enough cash is found internally and the overall cash outlay is decreased, then perhaps the cash that is coming from the business will be enough to sustain growth.

But, it’s clear that if they want to continue to grow at the same rates as they have done in the past, they will have to look to external sources: banks, private equity houses, and strategic investors that take a stake in the firm. There are no other ways.

IA: When you talk about finding liquidity inside the business, is that what you mean by a “liquidity mindset”?

Yes, exactly. This is an industry that is used to having huge expenses which, in many cases, are superfluous.

You will remember that Mr. Della Valle, CEO of Tod’s, said during his speech that he didn’t know why we have to pay photographers so much. I would add: Why do we always have our employees stay at five-star hotels? Why do we have to pay so much for top models?

There will have to be a resizing of the entire amount of expenses of luxury companies in the coming months. And, if they manage to cut costs more than the sales decrease, they will find benefits in real equity terms and will increase their chances of survival.

IA: Finally, I wanted to get your thoughts on the outlook for the luxury industry in the next six to twelve months. Are you optimistic or are you still quite bearish about the prospects?

That depends on whether luxury companies have the capacity to act quickly.

What is important is that they don’t end up in a situation at the point of no return. This is what worries me most. We can do everything we can to help, but after a certain point, there is little we can do to return them to stability.

Unfortunately, I imagine a concentration of the industry. Big players will stay in the market. But, there are also many other brands that have grown from nothing in the last few years – and for them, honestly, the question of survival is a real issue.

Think about it this way. If you look at the offer out there, it is so wide. In every category, every price range, every style, every colour, there is infinite product available. For the consumer it has become hard to choose. There are so many opportunities that, at a certain point, the consumer will stop buying or, perhaps, will not buy as much as he did in the past.

Small companies must therefore have something really new to offer the market, or I am afraid, they will disappear.

Imran Amed, Editor-in-Chief