Road to ruin...

An aggressive expansion programme has been cited as lying behind London and Edinburgh Swallow Groups' downfall, although it was a strategy that group founder Alan Bowes felt could be sustained.

Emerging from Kingston Inns when it failed in the recession of the early 1990s with a handful of tenanted pubs, the new business, London Inns, grew to about 50 units by 1996. Run from small rented offices in Maidstone with an expanding team headed by Bowes, the company obtained funding from a mixture of brewery and bank debt. Expansion was core to its strategy, and loyalty was a major factor in an employee's development.

With the financial support of NatWest Bank and Carlsberg, it kept acquiring while its business model was based on continued expansion to achieve maximum discounts from the national brewers, in particular Carlsberg. This relationship was to form a key element of the massive growth that followed.

A number of property agents suggested that sale and leaseback was a good way for the company to expand without the requirement to invest large sums of cash.

The sale and leaseback method of funding involves three players - a property investor, a pub company and a lessee. The pubco, in this case London Inns, would buy a freehold pub site. This site would then be sold immediately on to the property investor, the Khalastchi brothers were one of London Inns' key investors, who buys the freehold of the site thus returning the cash to the pub company, and also agrees to lease it back to the pubco at an agreed annual rent.

The pubco then sub-lets the site to a lessee, an individual licensee who will run it as any pub tenant or lessee would, paying an agreed annual rent back to the pubco that should cover the rent being charged by the freeholder property investor.

Thus the property investor has a return through the rent from the pubco, the licensee can build his business and hopefully make money above and beyond his annual rent, and in theory the pub company can make money through rent increases on successful pubs, and bulk supply deals through tie agreements.

In practice it seems the sale and leaseback method fell short of London Inns' expectations. London Inns started to use the sale and leaseback structure intensively five years ago. In 2001 the company needed a stronger covenant than its own to convince investors that their money was going to be safe in a business that was just becoming a limited company and had limited financial resources.

The Winlease venture

With this in mind London Inns and Carlsberg then formed a joint venture tenanted pub company called Winlease Ltd in 2002. The rationale for the company was that Carlsberg would guarantee the payment of head rents to investors until Winlease became strong enough on its own. Carlsberg's exit was to be the achievement by Winlease of certain profit figures. The brewer estimated that it would take four or five years of trading before it would be automatically released from its guarantee.

Meanwhile, Carlsberg had an exclusive supply deal with Winlease on normal commercial terms. This structure had the attraction to Carlsberg of gaining additional beer volumes without investing any of its cash. Winlease began life by acquiring 20 pubs in Liverpool from the receivers of a local pub business, yet the pubs proved a poor investment and a subsequent millstone around the company's neck.

The underperforming pubs could not be sold because Winlease did not own the freehold and investors were unwilling to accept a capital loss. It became a feature of the London Inns business that capital expenditure - even basic repairs - took months to approve and then complete, giving long periods when the pubs were not trading to anything like their potential.

But the company continued to pay head rents to investors on pubs that were closed since they could not find suitable licensees to run them. Subsequently many of the pubs had a high turnover of tenants. More acquisitions saw Winlease grow to 120 pubs in around 18 months. However, factors said to include poor operational management - allowing buying out - and a failure to upgrade the finance function in line with expansion meant Winlease's performance consistently fell below Carlsberg's expectations.

The Swallow hotels

Meanwhile, London Inns had acquired the small number of Swallow Hotels, and the brand rights, and so changed its name to London & Edinburgh Inns (L&EI). The company continued to apply the sale and leaseback formula and assured investors its covenant was now strong enough to be acceptable to the investment market without the need for any third party guarantee.

Acquisitions mounted, but the ability of the L&EI business to monitor and control the performance of past acquisitions did not improve.

By late 2004, Carlsberg had decided to exit the joint venture and L&EI bought the brewer's 50 per cent stake in February 2005, in exchange for a continuation of the supply deal. Despite Carlsberg's caution the expansion of London & Edinburgh Inns barely paused for breath.

Property profit became a key criteria for site acquisition. L&EI executives legitimately shared in the profit on the sale of other freeholds.

These profits would be generated because of rising property prices and because a property with a head lease to a pub company was a more attractive investment than one without.

This led to freeholds being sold at auction with good profits within a few months of acquisition.

However, one market source indicates that overall losses last year were £12m and forecast to be close to £20m this year. Other observers note that while Bowes points to Companies House for a true picture regarding the health of his company, margins were simply boosted by sale and leaseback income. When the rent cannot be paid, this business model melts away.

Meanwhile, administrators have a huge job on their hands unravelling the business, having already shuttered dozens of pubs and hotels (see page 19).

Such closures, one observer noted last week, signify they think the business is not worth supporting - despite the key role of an administrator being to protect the business from creditors.

Why L&ES collapsed

Insiders suggest the reasons for the collapse of the group include:

• the business focussing on expansion while the trading performance of the previous investments was comparatively ignored
• the finance function being under-resourced and subject to "inappropriate appointments". There was certainly an inability to forecast cashflow accurately, suggest insiders
• the business lacking experienced management to deal with the new larger organisation while loyal people with skills not related to their responsibilities were stretched beyond their capabilities.