The facts are hard to Swallow

What is left of the London & Edinburgh Swallow Group (LESG), the hotels and pubs business that last week entered administration after “struggling with mounting losses”, is an ugly mess. While the news that a prominent business in the sector had fallen over was troubling, there was a grim inevitability about the situation, given the model that has been adopted by LESG. For those unfamiliar with LESG's modus operandi, this model, in the politest terms, could be described as utterly flawed. Backed by property companies, LESG has grown quickly in the past five years through the acquisition of pubs and hotels, often in packages from rival trade players. After completing each acquisition LESG would typically sign long-term leases with its property partners, which include the Pears and Khalastchi families, but at a far higher level than historic rents at these pubs and hotels. This increase in annual rental yield, whether sustainable or not, had obvious implications on the value of the freehold property. Many of these properties would then be placed for sale at auction - with the freehold valuation calculated on its new rent - and be sold to third party property investors. LESG's property partner would be out, in most cases having made a profit on the property, ready to make the next acquisition. LESG had a profit-share agreement, which meant it also saw a portion of the upside from any onward sale. The increased rent levels that allowed LESG and its property partners to sell freeholds at these vastly superior levels, proved unsustainable. A very high proportion of the properties placed with administrators last week are cash negative after rent, and before central support costs. Sources suggest to me that for a period LESG used some of its profits from property auctions to make up the shortfall between cashflow and rent. All the while LESG and its property partners were acquiring - and feeding the machine - it was not a problem. But in the end this flawed model caught up with the company. LESG did not own any freeholds, it never did. The assets placed with administrators at Ernst & Young largely relate to fixtures and fittings. The “business and assets” owned by LESG at 240 properties have been acquired by Flodrive, the Khalastchi family property vehicle. It is thought that the Khalastchi's still owned some properties owned by LESG so there is a fair chance that some of the leases will be repatriated with the freehold. But this still leaves the central functions related to, and fixtures and fittings of, more than 400 pubs or hotels in administration. These properties are owned by over 300 small investors and business entities. Depending on which creditors are first in line to be paid, this means that administrators could whip out the fixtures and fittings to raise funds to pay off the company's debts. As one source close to the situation told me last week: “The investors that bought at auction are completely exposed - it's pretty hard to run a hotel without beds or a pub without a bar and chairs.” And some licensees are also caught up in this unfortunate mess. LESG had a sizeable tenanted business - it sub-let pubs and hotels to individual licensees. Apparently these operators had to learn from the newspapers the fate of LESG and some suppliers are now refusing to deliver goods - and it's pretty hard to run a pub without beer or food to sell. The people that acquired these properties at auction clearly did not undertake the proper due diligence into what these commercial properties were worth. But it is easy to understand why, given that they had a sizeable lessee in place - a 700-strong pub and hotel company with a strong convenient. There will be many people that lose money from the situation but it is not the banks - LESG was not a highly-leveraged company. It is the third party investors and possibly LESG's licensees. The only way to fix this in the long-term is to restructure the rents attached to the properties, which will have inherent implications for freehold values. Many people will own properties worth a lot less today than they seemingly were when acquired at auction. And presumably there are a few people that have made a lot of money from this flawed model. This is not the first business failure of Alan Bowes, the executive chairman of London & Edinburgh Swallow Group, it is his third.