SERIES: THE CRUNCH FITNESS FIASCO

THE FUN & SEXY CRUNCH FITNESS BALLYSWINDLED & OVERLEVERAGED

By David Arthur Walters THE MIAMI MIRROR June 10, 2011 MIAMI BEACH A stockbroker by the name of Doug Levine, a would-be architect and standup comedian whose creative interest was whetted as a child while building sandcastles in Florida during Christmas vacations, thought gyms were too serious; he wanted exercise to be fun, so he catered to his New York contemporaries, investing the $80,000 he had earned as a Wall Street trader to establish the first Crunch in 1989, naturally at St. Marks Place in the East Village. Levine saw the stampede into fitness clubs coming and put his Crunch brand on a goodly portion, a brand suited to the growing dissatisfaction with Corporate in all its forms; a brand that, first of all, means Fun. Crunch combined fitness with entertainment, appealing to young members who want to have fun working out and enjoy themselves without getting stoned, featuring the latest fitness gimmicks and unusual classes like pole dancing. Crunch differentiated itself from the herd, welcoming people alienated from all walks of life, by standing out, by engaging in antics, by being odd-ball, outrageous, weird, novel, audacious, zany, goofy, ugly, and off-the-wall. When this Crunch brand lover joined the club in 2006, Crunch was a place where ladies could get rid of shyness and become sultry vixens. I suggested they give the sexy and challenging Pole Dancing class a whirl for upper body and core strength however, I warned the general manager about some of the dangerous practices, such as beginners wearing French heels in the South Beach class, taught by a dancer that literally made me drool and offer to become her slave. There is nothing like a natural high, I enthused, so you may want to sweat off yesterdays hangover at Crunch, and become drunk with Crunch Power. For Happy Hour try the cardio Strip Bar class it takes Striptease to the next level. Fight off the sleazes with Kickboxing, Kardio Combat, or Cardio Capoeria, and dont forget to do the Samba, Zumba, Urbante, or whatever, and then chill out with Yoga and Pilates. Bicycle Spinning sessions and Yoga classes are packed. Crunch classes have plenty of gimmicky accessories, the latest thing being a kind of pogo stick. In sum, almost anything is done to distract the Cruncher from the arduous facts of strenuous exercise by making the fitness endeavor as fun as possible. Levine had little difficulty selling Crunch to Bally Total Fitness for $90 million or so in 2001. Crunch was not just another gym, here today and gone tomorrow. The brand was well known, as

funny and sexy, counter-cultural in a healthy way. That being said, business was not spectacular as the small fitness chain matured, and it was sorely neglected when it was held by Bally Total Fitness; yet Crunch appeared to be a brand that would survive for years to come if properly managed. No one predicted that Crunch would wind up in bankruptcy after partners ostensibly led by fitness industry titan Marc Tascher of Town Sports International fame bought Crunch in 2005 for $45 million from troubled Bally Total Fitness in an attempt to rejuvenate the clubs. Nor did any outsider imagine that the equity firm Angelo, Gordon & Company, which was really in charge of Crunch management, would shove the duped Tascher aside after four short months, allowing Mark Mastrov of 24 Hour Fitness fame to horn his way in to stalk and buy the brand in bankruptcy as planned, in order to perpetuate a franchising scheme that would result in the virtual McDonaldization of Crunch see our previous article, Welcome to McCrunch. Ballys origins hail back to 1931 and Lion Manufacturing. The pinball product Ballyhoo was a big success, therefore Ballys name. Bally went into slot machines, opened up casinos, manufactured exercise bikes, and, in 1987, became the largest fitness center then operating in the world, having around 440 centers by 1996. But Bally did little to promote and maintain the integrity of the Crunch brand, and confused it with the Bally brand, which had, as a result of several scandals and lawsuits, become virtually synonymous with financial and consumer fraud. ConsumerAffairs.com reported that, "We get so many complaints about Bally Total Fitness that it's a workout just to sort through them." In 1994, for example, Bally settled SEC charges for illegal billing, cancellation, refund, and debt-collection practices. More than 600 members complained to the New York Attorney General about its practices from 1999 to 2004. A SEC investigation into its accounting practices resulted in revision of its financial statements for the years 1997 t0 2003. The SEC filed financial fraud cases against it in 2008 for exaggerating its equity by $1.8 billion for 2001, and underreporting its loss in 2003 by $91 million. As late as 2010, the Texas Attorney General accused the company of sending out 11,000 fake past due notices to former members in an effort to induce them to rejoin the clubs. In 2005, destined for two bankruptcies in short order, Bally agreed to sell its 21 Crunch clubs plus 2 Gorilla Sports Clubs and 2 Pinnacle Clubs for $45 million to Marc Tascher and investors led by Angelo, Gordon & Company, a $10 billion private equity firm specializing in distressed properties. Tascher, owner of Sports and Fitness Ventures LLC, kicked in the six of the eight clubs he controlled into the deal, taking for himself a 20% equity interest in the acquisition partnership, AGT Crunch Acquisition LLC, along with the management contract. Given Ballys history of unscrupulousness, it is hardly surprising that it cheated the buyers: the purchase agreement promised to convey 97,538 members; when the dust settled, the acquirers, with 80,188 members, were 17,350 members or 18% short of the number promised, which would diminish expected revenue by around $1 million per month. On May 18, 2007, AGT Crunch Acquisition sued Bally Total Fitness for over $10 million, stating in its Complaint that, In the Purchase Agreement, the Defendants grossly overstated the number of memberships held by the fitness clubs being sold, and overstated the quality of the types of Membership Contracts. Since the main source of revenue for fitness clubs is the membership fees and dues they collect, these misrepresentations were very material to Crunchs financial analysis and a major factor in valuing the fitness clubs. The Defendants also breached the Purchase Agreement by failing to provide Crunch with all of the Membership Contracts related to the fitness clubs being sold,

hampering Crunchs efforts to determine precisely what each Membership Contracts terms are. Alas for Crunch, Bally went bankrupt twice since, and the suit is probably not worth a wooden nickel now that the bankruptcy stay has been lifted. The new Crunch Fitness investors and creditors had laid out their money at the height of the madness that led to the credit panic that nearly doomed the economy. The Crunch partners had raised not only equity but debt for the purchase and growth. Our financial information is sketchy because the companies involved are private. We have a purchase price of $45 million, plus $30 million scheduled for renovations, plus working capital would be needed to cover deficits. Let us presume that the total funding was $97 million. By August 2009, according to a statement filed with the bankruptcy court by the debtor AGT Crunch, there was $58 million in capital paid in, $78 million in secured debt, and another $25 million in unsecured liabilities owed to members, landlords, and other creditors. Accumulated losses were $(61) million, leaving the firm with a deficit of $(3.7) million. Secured creditors had a claim on nearly 78% of the total assets, but $64 million of the asset value was for intangibles goodwill and the Crunch brand of dubious value given the situation, so in effect the secured creditors claim was 1.64 times the recalculated assets after deducting intangibles. Interest expense booked for four months ending August 31, 2009 was an extraordinary 20% of its revenue. Now we have alluded to leverage, which may be calculated in different ways; very often it is referred to as the ratio of debt to equity, with some rate or the other being considered as optimum. Crunchs ratio of debt to equity was not 2 to 1, nowhere near the 9 to 1 analysts usually consider dangerous, and far below the 19 to 1 of the Trump Shuttle fiasco, or the 32 to 1 of Robert Campeaus Federated Department Stores debacle. Crunchs leverage ratio may not have appeared dangerously high to the cocky optimists who were blind to the signs of the inevitable downturn. Nevertheless, we think far more equity should have been contributed by the equity firm which was said to have around $10 billion reportedly under its management at the time. And, if it were not for the extravagant evaluation of the brand and for goodwill, was not too much paid to the seller? But what can be positively said about the debt to equity ratio if there is no equity left for the division when business goes south, yet the technically insolvent firm may be able to sail ahead for awhile on cash flow? Another method may be used; for instance, the deficit may be deducted from indebtedness; the sum, called total capital or net capital, may be compared to the indebtedness here capital means resources contributed by both lenders and equity investors. At the time Crunch petitioned for bankruptcy, its secured indebtedness was stated as $78 million and its deficit as $(62) million, resulting in total capital of only $16 million, so its secured indebtedness would be a frightful 4.88 times its so-called total capital. Another ratio commonly used is that of indebtedness to earnings before interest, taxes, depreciation and amortization; but Crunch had no positive EBITDA for the ratio, i.e. no wherewithal even to pay the interest on the loans. In our lay opinion, Crunch Fitness was undercapitalized and overleveraged in the first place, and, to make matters worse, the crisis management consultants and lawyers, whom we shall identify in a separate, conspiracy-theory essay as a professional blood-sucking vampire brood, bled its cash flow for millions of dollars in fees.

However leverage is calculated, there is no such thing as a risk-free investment or riskless capital structure, as has been made painfully evident again by the most recent credit crisis and collapse of equity values the biggest insurance companies may fail as well as governments; although few people knew it, the survival of the United States as we know it was at grave risk. Still leverage can be good for equity investors when things are going well. The advantages of leverage, of using equity or margin as a lever to borrow its multiple in debt, in effect to employ more assets in the enterprise at a higher rate of return than the interest on the loan used to acquire them, have been rediscovered in many good times. Indeed, the virtues of leverage have been hailed since the invention of paper money backed by hard currency or assets such as gold, land and tobacco. The extent of such backing diminishes paper in circulation increases when it is discovered that not everyone will come to claim them at one time. The higher the leverage the higher the risk, but an ambitious people soon forget past debacles. Again, as every banker knows, borrowing money at the right interest rate can produce high returns to the equity investors when thing are going well; however, the greater the amount borrowed, especially at the wrong rate, the greater the risk of bankruptcy when the payments cannot be made on time during bad times, leaving the equity investors empty-handed after the secured creditors claims are taken into account. Goldman Sachs, long celebrated as a veritable genius of leverage, set up Crunchs primary credit facility. Now Crunch was losing money hand over fist. Membership had waned from 80,188 to about 73,000 by the time its bankruptcy petition was filed May 2009. Revenue was $5.8 million for the month of August 2009, on which it lost $1.8 million. The value of the membership shortfall due to the Bally Total Fitness swindle was around $1 million per month, not enough to cover the monthly loss, but from that we would have to deduct the membership erosion due to the recession as well as additional costs associated with the higher revenue. In fine, if we take into account the factors stated to the bankruptcy court to explain the need for reorganization, increasing the membership revenue and reducing the rent accordingly would still not provide operating income sufficient to pay interest on the loans. Another ruinous factor, one not mentioned as causative to the court: salaries, commissions, fees and payroll related expenses were running a whopping 52% of revenue, when 38% or less should have been more than sufficient for a company of its type. Angelo Gordon apparently likes to pay out enormous fees to friendly outside consultants, paying around $1 million a month to Alvarez & Marsal for an invasion of its consultants into several key Crunch positions, extraordinary expenditures to which we think the marginalized Tascher, as an equity holder at least, must have vehemently objected given his long history elsewhere of maintaining a loyal staff and keeping administrative expenses down. Angelo Gordon, incidentally, has not responded to our attempts to ascertain the facts of its relationships and operations in regards to Crunch. Jeff Feinberg, which it installed as interim CEO at Crunch along with other persons imported from crisis management firm Alvarez & Marsal, did state that he had nothing to say because he was no longer with Crunch. We shall opine elsewhere that he was with Crunch in title only. To Be Continued