Fortune, then LESG took a huge tumble

A few more words on the demise of London & Edinburgh Swallow Group (LESG) seem appropriate. This is, after all, the most worrying collapse since investors in Slug & Lettuce operator SFI Group discovered that their equity stakes in the leasehold pub operator were worthless.

In this one respect the companies are similar - both have/had entirely leasehold estates where rents are/were far too high. In the case of LESG, though, there is one startling difference. The company was instrumental in setting the rents that caused its failure. Strange, eh? Let me try to explain. In December 2003, Flodrive and William Pears, property companies working in partnership with LESG, bought 252 pubs from Punch for £57m - around £226,000 per pub.

These pubs were being off-loaded quickly by Punch in the wake of its acquisition of Pubmaster. They were a combination of pubs from both estates and were sold to satisfy petty sessional division rules, which limit a single company's ownership of pubs within each licensing district. In retrospect, the pubs were an absolute bargain because they were bought for just eight times earnings - similar estates are now selling for around 10.5 to 11 times earnings.

They sold so cheaply because the market for them was quite small at the time. Admiral Taverns, the principal buyer of these kinds of pubs in recent years, was a fledgling entity and came second in the auction.

If LESG companies and Flodrive had retained the freeholds of these 252 pubs the fundamentals were in place for a very solid business. The gap between the cost of finance and the return from these pubs was sizeable - somewhere around 6%. In other words, it was perfectly possible to make around £3m or £4m in pre-tax profit on these venues per year. Instead, another course of action was taken.

By my reckoning, around

150 of these pubs were sold

to private investors at

auction houses in 2004. Examining 77 of these sales

I have calculated that investors paid an average of around £140,000 each more for them than had paid a few months before.

Multiplied out across the 150 pubs, this would produce an instant profit of around £20m. The only problem, of course, was the LESG estate was effectively mortgaged to the eyeballs after the auction sales.

Why did the pubs sell for such a large profit? Investors

were buying a pub with an LESG company signed up as a sitting tenant offering very high rents. Sources suggest

rents being offered by LESG to investors were four-fifths

of total house earnings - most sale and leaseback are

set at 60%.

The problem with an estate of pubs such as this is that churn levels tend to be higher than the industry average. Each week a pub is without a licensee (who, incidentally, is little more than a holder of a sub-lease) means LESG companies pay the entire rental income for the week to the investor without any earnings from the pub.

Moreover, the level of rent-to-income gearing is very high in absolute terms, leaving very little profit margin for LESG companies.

At each and every one of these pubs sold at auction

LESG companies (Newbold is the most common subsidiary offered as leaseholder) were left with very little in the way of profit for themselves.

At the point of administration I understand north of 70% of LESG's pubs and hotels were cash negative. For private investors, the collapse of LESG could mean a huge drop in rental income. LESG would have been able to earn the usual £130-a-barrel discount.

These discounts will drop for the freehold owners buying beer from breweries or wholesalers.

One big winner might be the major brewers who have

one less scaled-up operator to deal with. It's astonishing, though, that LESG could be bust within two years of generating a £20m profit on a set of 150 pubs that had cost circa £34m.