The biggest business busts and what you can learn from them

Elizabeth Holmes is currently in court, facing 12 counts of fraud over her role at Theranos, the now notorious blood-testing firm that was once an illustrious Silicon Valley unicorn. The trial comes more than three years after she was indicted on charges of defrauding investors, doctors and patients on the capabilities of Theranos.

Having founded the biotech in 2003 at just 19, the promise of her revolutionary technology - which pledged it could detect thousands of illnesses with just one prick of blood - saw Holmes shoot to stardom. Meantime, her Steve Jobs-esque style encouraged further media frenzy. 

She graced magazine covers, gave a TED Talk, and spoke on panels with the likes of Alibaba's Jack Ma and Bill Clinton. She secured early investments from Oracle's Don Lucas and Larry Ellison, and venture capitalist Tim Draper. The founders of Walmart and Rupert Murdoch also reportedly backed the burgeoning biotech with multi-million dollar investments. At one point, Forbes dubbed her the "world's youngest self-made female billionaire" with an estimated net worth of $4.5 billion. 

By October 2015, Wall Street Journal reporter John Carreyrou published his investigation into the biotech's struggles, revealing Theranos had been using traditional blood testing machines to run its samples after its own "innovative" system had failed. Soon after, a throng of regulators was knocking at Holmes' door. 

Forbes has since revised her estimated net worth at zero. 

While the rise and fall of Theranos is truly infamous - inspiring books and a rumoured Hollywood adaption starring Jennifer Lawrence, it isn't entirely unique. 

In this wire, I spoke to two long/short managers - Perpetual's Anthony Aboud and Totus Capital's Ben McGarry, for their insight into some local historical business busts, as well as the lessons you can take away from these fads, frauds and failures now. 

A brief history of Australia's big business busts 

McGarry and Aboud agree that there are clear parallels between some of Australia's great business busts, despite these companies operating in very different industries and with varying catalysts for what would be their ultimate downfall. 

These can be difficult waters to charter, McGarry adds, as fraudulent businesses are often the most litigious, promoting themselves at any chance they may get. In the meantime, real companies often just get on with business and don't worry too much about investment markets, hedge funds or short-sellers, and let the numbers do the talking instead. 

Aboud points to Babcock & Brown and Slater & Gordon as clear examples of the former, while the downfalls of Dick Smith, Quintis and Blue Sky Alternative Investments have been etched into McGarry's memory. 

In the majority of cases, these companies were over-geared, paraded questionable cashflows, boasted unsustainable business models, and used cheap debt to fund and grow their businesses. Another common feature, according to Aboud, is that a handful of these companies' management teams and boards blamed short-sellers for their undoing. 

These historical business busts are still relevant today, as these companies used "cheap debt and "big talk" to grow within their sectors, Aboud adds. Given the current accommodative environment, it may pay to be a little bit cautious.  

So, let's take a look at some of the big ones, shall we? 

Blue Sky Alternative Investments

Ahhh, Blue Sky ... a business bust that took more than $1 billion in shareholders' savings down with it. At one point, the Brisbane-based fund manager had a valuation of $1.2 billion and managed more than $4 billion for its investors. The ASX-listed company invested in private asset classes like property, start-ups, private equity and real assets, before a Glaucus Research short report kickstarted its downward spiral. 

"The thing that was interesting about Blue Sky was that they were generating quite strong revenue and profit growth and growth in assets under management, however, their cash receipts were far lower than the reported profits," McGarry explains. 

And yet, the company wasn't paying a lot of tax, he says. 

"I think at one point they had about 80 different funds sprinkled across a variety of asset classes. And the returns for almost all of the funds that they were reporting publicly were very good - they were in the 15% a year type range," McGarry says. 

"It looked improbable that the returns across so many different assets were so consistent - it was too good to be true. There was an absolute absence of negative news." 

In addition, Blue Sky would come back to the market to raise equity every 12 to 18 months. However, McGarry argues that if a fund manager is earning management and performance fees and is reportedly growing assets, the business shouldn't really require this external capital. 

"So they were the tells. And then eventually the Glaucas report came out and said some of these returns look wrong, you've got this huge receivable in your accounts for fees that are owing from the underlying funds, and those underlying funds aren't generating any cash," he says. 

"And that was enough to cut off their access to capital. The rest is history."

The warnings signs were in the accounts, while the absence of bad news should have also triggered an alarm for investors, McGarry says, as even the best investors have their "hiccups". 

Quintis

West Australian Indian sandalwood producer, Quintis, experienced similar success before it crashed and burned. In fact, at one point, it used former cricketer Adam Gilchrist and F1 racing star Daniel Ricciardo to promote its business. 

But in 2018, a Glaucus report described the business as having a "Ponzi-like structure" and claimed its biggest client, China-based Shanghai Richer Link, was actually a "tiny commodities importer with minimal operations". 

Like Blue Sky, Quintis also reported very strong revenue and profit growth but very poor cash collection, McGarry says. And it also had a large array of adjustments in terms of the types of profit it would report to the market.

"There was accounting profit, then adjusted profit and then cash profits. It was a choose-your-own-adventure for which one of those you wanted to believe. So the accounts were complicated. And again, it didn't appear to pay a lot of tax," he says. 

It was also in an industry where all the competition had gone bust, McGarry adds. 

"If one company is left standing in what's clearly a pretty difficult industry to make money in, it's worthy of a closer look," he says. 

"But again, that lack of cash generation and the constant requirement to come back to equity markets to raise money were red flags for Quintis as well. And again, the catalyst was a Glaucas short report."

Dick Smith

Founded in 1968 by Dick Smith himself, this electronics retailer changed hands twice before its ultimate demise. Smith and his wife sold 60% of the business to Woolworths in 1980, and the remaining 40% two years later. It was then sold to Anchorage Capital Partners in 2012, which hired a new CEO and management team. Four years later it went into voluntary administration.  

The trials and tribulations of Dick Smith were a bit more tricky for the average investor to pick up, McGarry says, however, those with an accounting background may have spotted them. 

"Dick Smith had a noticeably large receivable in their accounts relative to their revenues," he said. 

"And when you think about what Dick Smith is, which is a chain of electronic retail stores. And you would typically walk in there, find what you wanted, pay with either cash or credit, and walk out with your purchase. 

"So who or what was this multi-million dollar receivable? Because they were direct to consumer - they weren't a wholesale business. So somebody owed them a big chunk of money."

McGarry says his team asked about the receivable several times, but only received vague answers in response. 

"When the business went bust it came out in the wash that they had been buying large amounts of inventory in bulk from suppliers and then receiving volume rebates for those large purchases," he explains. 

"They were able to book those rebates as profits. And they were buying inventory to maximise those rebates, rather than what was best for the business or their customers, and that contributed to the collapse." 

Slater & Gordon

Slater & Gordon was one of the world's first listed law firms, with shares hitting a high of almost $7 in 2015 before a spectacularly painful decline to where it now trades on the equivalent of 0.8 cents following a 100 for 1 share consolidation.

Like Dick Smith and Quintis, there was a large degree of subjectivity when it came to recognising Slater & Gordon's profits, McGarry says. 

"It was on investor's radars because as a law firm, they would hold these cases and then estimate the likelihood of winning the case. They wouldn't collect any real cash unless they won the case in their litigation business," he explains. 

"But Slater & Gordon would often recognise revenue well before that, based on the probability or likelihood of winning. It just looked like there was a lag and potentially a mismatch between the amount that they were booking as revenues and the eventual cash collected. So that was one red flag."

Aboud agrees, noting this strategy culminated in large accounts of receivables and works in progress. 

"When these sorts of companies grow quickly, cash will lag accounting profit and the market has to assume that the company is accurately predicting the collection of cash," he says.

"This in isolation is not a problem, as long as the cash follows the profit recognition with the fullness of time. However, if the cash does not come through to match the assumptions and the balance sheet is geared, then things can get ugly pretty quickly." 

At this point, a company has two choices. The first choice is to slow down its growth to allow the cash to catch up to the accounting profit and demonstrate the sustainability of the earnings. The second choice is to continue to grow through acquisition and aggressive organic expansion, raising debt and equity which will make it difficult for the market to detect any “over-optimistic assumptions”.

"It seems, by and large, that Slater & Gordon went down the latter route and the rest is history," Aboud says. 

McGarry believes it was the UK-based Quindell acquisition that led to Slater & Gordon's unwinding. This followed a slew of acquisitions of other legal firms in the UK, after entering the market in 2012. 

The firm purchased the professional services arm of Quindell in 2015 for $1.3 billion. A few months later, the fresh acquisition was the subject of a fraud investigation, while the UK's Financial Conduct Authority forced Quindell to restate its previously reported profits as a loss. Slater & Gordon reported losses of $1 billion in its reports in February 2016 in light of the transaction. As Aboud says, the rest is truly history. 

Babcock & Brown 

Babcock & Brown was a global investment and advisory firm that has been penned as one of Australia's worst corporate downfalls in history. At its height, it had a market capitalisation of $9.1 billion, with 1500 employees spread across 28 offices around the globe. In this case, it was the Global Financial Crisis that broke the camels back. And in March 2009, it was placed into administration. Five months later, it was liquidated. 

"This was a very complicated business which evolved over time," Aboud says. 

"It started as an advisory business in asset-backed transactions but evolved to be a principal investor and then a fund manager. The business model towards the end involved setting up quite a few listed satellite vehicles which were externally managed by Babcock & Brown."

These satellite vehicles - which generated yield from hard assets - were highly sort after by investors in an environment of low-interest rates and rising hard asset prices, Aboud says, with the business making its money by buying, warehousing and then selling assets like power plants, toll roads and wind farms for a material profit. 

"By and large, this can be a good sustainable long term business. The key to this is making sure they are well managed, sustainably geared investment vehicles that stick to their mandate and create value for the unitholder," he says. 

"However, as the manager, it can be very tempting to maximise short term profitability by selling assets off your own balance sheet at inflated prices, charging exorbitant fees and over gearing the satellite vehicles. This will maximise short term profitability in the management company however will result in the inevitable demise of the whole platform."

The problem for Babcock & Brown was that it was heavily geared - by over 50% - forcing it to become reliant on selling these assets on its balance sheet to existing or new satellite vehicles, Aboud explains.  

"When the satellites collapsed, Babcock & Brown was caught with an over-geared balance sheet and no way of selling its assets and its demise followed soon afterwards," he says.

"At its peak, almost all of Babcock & Brown's pre-tax profit of just over $770m came from profit on the sale of assets. The buyer was predominantly one of the satellite vehicles." 

Working out how much the satellite fund would pay for these assets was riddled with conflict, Aboud explains, as a higher price would increase Babcock & Brown's profit but would be value destructive for the satellite. 

"It seems that over time, Babcock & Brown may have erred on the side of maximising short term profitability to the eventual detriment of the satellites (and hence itself over time)," Aboud says. 

"In periods of falling interest rates and rising asset prices, everyone was happy. But when the GFC hit – things got a little more difficult." 

What you can take away from these sagas

While there are several lessons that can be taken away from these five business busts, Aboud warns that investors need to be careful that they don't over-simplify the catalysts. 

"A lot of great Australian companies have been formed through entrepreneurs aggressively growing their businesses through organic and acquisitive means. Macquarie Bank and Westfield are two examples of this," he says. 

A lot of money can be made by backing smart and aggressive entrepreneurs early, he adds, and watching them grow over time. 

"However, for me, the two most important lessons to glean from these episodes are to keep an open mind when it comes to your investments and to heed red flags when they present themselves," Aboud says. 

This requires a deep understanding of the business model, working out its weaknesses and having an understanding of what indicators might forewarn that the business model is under pressure, he says. 

"The most important thing as an investor is to wake up each day with an open mind. With Slater & Gordon and Babcock & Brown, the early backers had made a lot of money. However, both companies exhibited a heap of red flags before their ultimate demise. Selling is an extremely difficult discipline," Aboud says. 

This discipline can often be more difficult when an investor backs a management team early. After all, if you have made a lot of money from an investment, it may be harder to let go. 

"However, if the investment thesis changes and the company exhibits some big red flags, then you need to have a serious think about whether or not you should sell," Aboud says. 

Meantime, McGarry believes investors can take away three key learnings from these business busts: 

1. Follow the cash – it's what counts in the long run.
2. Don’t rely on regulators and auditors to identify frauds – they are undertakers, not bounty hunters.
3. Be very careful being short companies with hot consumer products and charismatic/famous CEOs.

"The most famous shorter in the world is Jim Chanos in the US, and he talks about the golden age of fraud and the post-truth world - which is like Donald Trump. It's the idea that it's fine to say an untruth as long as they're big and you're successful," McGarry adds. 

This is the world we're living in, and there is a lot of that going on, he says. 

"Elizabeth Holmes is probably just too small, she actually gets prosecuted. But if you're big and you employ a lot of people, you tend to get a slap on the wrist," McGarry says. 

"There ended up being no charges for Blue Sky or Quintis from the corporate regulator."

Frank Wilson, the former Quintis CEO is currently fighting ASIC in court as the regulator moves to ban him from managing companies in the future. Meantime, McGarry says that while ASIC did investigate Blue Sky's collapse, in the end, it decided not to press any charges or disclose its investigation into the investment manager. 

“Disclosure of the confidential methodology used by ASIC could assist people to evade regulatory detection and action, as it would provide forewarning of ASIC’s considerations,” the watchdog said at the time. 

For those who are interested, check out these images from AFR reporter Liam Walsh, which show nearly completely blacked-out recommendations from the regulator on the case. 

What a time to be alive. 

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