09 February 2019

Who left the cakes out in the rain?

What? The collapse of a British bakery business is a loss to lovers of chocolate eclairs.

Why? It’s also an extraordinary indictment of the many cooks: executives, the chairman, the investors, the market analysts, the auditors and their overseers.

By Paul Caruana Galizia

Cristoforo Scalzo came from a small town in Sicily to the UK as a prisoner of war. He was held in a camp in Chingford, North East London made of two timber huts – a recreation hall and a dormitory – for Italian PoWs. After the war, he stayed in the UK. He met and married Ave-Maria, a young woman from northern Italy. His brother in law suggested that they open a café in the City.

They set up Speedy Snack Bar on the corner of Watling Street and Bow Lane in the shadow of Sir Christopher Wren’s city churches. “Speedy’s” served the bankers and the brokers, the City’s lunch crowd. But it did more than that. It made fresh cakes. It was unusual in that it provided Italian food, cannoli and pasta, cappuccinos and espressos, at time when those things were a rarity in the land of sandwiches, pies and mugs of tea.

The Scalzos had three sons: Enzo, the eldest, and twins Victor and Robert. I met Robert at his Sicily Restaurant near Victoria Station in London. His English accent is from Essex where he grew up. His Italian still sounds a bit Sicilian.

He worked in his father’s café as a teenager, earning £12 for a 4am to 4pm Saturday shift. “I was the one who’d walk into a café and know what’s going on – what’s wrong with the food, the counter, where things should go,” Robert told me.

In 1987 Enzo, who Robert described as the “entrepreneur”, was offered the opportunity to buy Patisserie Valerie, founded in 1926, by its then owner Renzo Rapacioli. They went for it and turned its Old Compton Street store into a Soho institution. The tables were long and customers had to share them. Each one had a different cake at the centre. Each day brought different cakes.

The clientele’s names came thick and fast from Robert: the designer Paul Smith, John Cleese, Michael Palin and the rest of the “Monty crew”, supermodel Liz Hurley. They made Eric Clapton’s birthday cakes. But the brothers insisted on treating everyone in the same way. They learnt customers’ names and sat with them. They knew their staff, Robert said, and pointed to Tony, his restaurant manager, to make the point: “Tony’s been with me since Valerie’s, for 25 years.” Tony nodded.

“It was never about the money,” Robert said. “The money always went back into the shop.”

Andrew Testa for Tortoise

Robert Scalzo at his London restaurant

As it turned out, it was all about the money and not about the shop.

Patisserie Valerie was a small group of British cafés that made its name as a family business. Taken over by a private equity firm in 2006, which then floated it as Patisserie Holdings in 2014, the company went bust on January 22 this year after its directors discovered a long-running and deep-rooted corporate fraud.

There have been bigger and more consequential corporate frauds than Patisserie Valerie’s. But looked at in detail, its story is an astonishing indictment of the company’s directors and its “serial entrepreneur” boss, the proforma standard of auditors, the buy-to-sell culture of private equity, and the laziness of investors and shareholders in the public market.

The rise and fall of Patisserie Valerie is a corporate morality tale of our times.

Café to corporation

In 1993 the Scalzos acquired a site on Marylebone High Street. A decade later they opened a store on Kensington Church Street. Robert liked that one: “You got all the French yummy mummies coming in after dropping off their kids at the Lycée. It’s important, you know, you need the community.” Another two stores in Chelsea and one in Belgravia followed in 2003; Piccadilly in 2005. That same year they opened one in a Norman Foster building in Spitalfields, which was to serve as the bakery supplier to all other stores. The expansion was steady and organic, each store opening has its own story, and Robert made each one look and feel different.

But by 2006 Enzo got itchy feet. He received an offer from a private equity firm called Risk Capital Partners, headed by investor Luke Johnson. Robert didn’t want to sell, but negotiated that he and Victor would stay on. “Four months later,” Robert sighed, “they said we only need one of you.”

Gregarious and nostalgic up to this point, Robert looked dispirited as he talked about the changes that followed. Cakes were no longer freshly assembled in stores. The shops were standardised and lost their individual personalities. “It ended up being a numbers business,” he said.

“The biggest problem was when they took on Druckers in 2007,” Robert said of a chain of cafés in and around Birmingham. “They lost the whole point.”

An internal document presented to HSBC in February 2007 outlined the case for the Patisserie Valerie-Druckers merger that created Patisserie Holdings. It described Druckers as being present in “small or large towns and cities”. Its demographic market – “B/C1/C2” – was made up of administrative workers at the upper end and skilled manual workers at the lower end. Patisserie Valerie, in contrast, was for “cities with upscale residents”.

It wasn’t a good fit. The parts – Patisserie Valerie and Druckers – were greater than the sum: Patisserie Holdings where Johnson was to reign as executive chairman.

Patisserie Holdings was formed. And, unlike its predecessors, it was a business that served financial investors rather than customers.

David Scott joined Druckers as a managing director and became a major shareholder in 2001. Like Robert Scalzo, Scott cared deeply about Druckers. He’s from Birmingham and still lives there. His mother used to send him to Druckers as a boy to pick up pastries. He didn’t want to sell out to Johnson and the regret is still there and it is palpable when we speak.

Johnson, Scott claims, went behind his back and bought out his two ageing partners in the business.

“I left a very good business and a very good team,” Scott said. “Everyday I was completely connected. I knew exactly which stores weren’t performing. I knew how many lightbulbs were out. I went into most of the stores and saw which ones had messy tables.”

“Patisserie Holdings,” Scott said, “was just rebranding Druckers stores.”

Tom Pilston for Tortoise

David Scott in Birmingham, February 2019

In its 2017 report Patisserie Holdings boasted that “the Group has been effectively managed by the Executive team since 2006 growing the business from annual revenues of £5m from eight stores to £114m from 199 sites in 2017”. But it didn’t say how. Patisserie Holdings grew to 3,000 employees across 200 cafés in the UK and Ireland through an aggressive acquisition programme that moved quickly and incorporated disparate units. One expert I spoke to, a business professor at an elite university, said that Patisserie Holdings “grew in a very undisciplined way”.

“I watched this business and it went absolutely crazy,” Scott said. “Johnson didn’t question the company’s amazing performance, and no one questioned him.”

Andrew Testa for Tortoise

Patisserie Valerie's Knightsbridge cafe

Patisserie Holdings’ 2017 annual report turned out to be its last. Trading of its shares on the London Stock Exchange junior market was suspended on October 10 2018 when Johnson said that the company came within “three hours” of bankruptcy. Johnson was until then celebrated as Britain’s “serial entrepreneur”. He once wrote, in one of his seven business books: “It’s a sad fact that if an entrepreneur employs enough people, sooner or later there will be a thief on the payroll.”

The company’s board had learnt of “significant, and potentially fraudulent, accounting irregularities”. Its cash position of £29m turned out to be net debt of £10m.

Finance director Chris Marsh was arrested and granted bail a day after the trading suspension. The Serious Fraud Office opened a “criminal investigation into an individual”, who most assume to be Marsh. A month after Marsh’s arrest, CEO Paul May resigned. Two months later, a company statement warned that the fraud was both deeper, involving “thousands of false entries into the Company’s ledgers”, and older than initially thought, stretching back to 2014. A few days later, on January 22, the company collapsed. KPMG, the administrators, announced the immediate closure of 70 stores and a “significant number of redundancies”. Its £581m valuation, including Johnson’s £189m stake, went up in smoke.

Johnson declined a request for an interview, citing stock market rules and the ongoing Serious Fraud Office investigation. The knives are now out for him, with a clamour of investors and shareholders demanding answers.

The wisdom of crowds

There were high expectations for Patisserie Holdings when it went public in 2014, trading as CAKE, with a share price of £1.70. Grant Thornton, its auditors, presented it with an “IPO [Initial Public Offering] of the Year” prize. Its share price reached £4.29 on the day trading of its shares was suspended.

They say that if something looks too good to be true, then it probably is. But in the year leading up to Patisserie Holdings’ collapse, shareholders earned a return of 25 per cent compared to -1.2 per cent for a major competitor, Restaurant Group, and -3.4 per cent for the market as a whole. A popular website declared in a headline that Patisserie Holdings was “smashing the returns” earned by the UK’s 100-largest companies. Its share price grew to 25 times its earnings, compared with 17 times for the industry and 15 times for the market.

Patisserie Holdings had even higher expectations of itself. Commenting on the company’s interim financial results in March 2018, Johnson said that the company had delivered “consistent profits” and remained focused on “organic growth” and using “a strong balance sheet” to acquire new stores.

To outsiders Patisserie Holdings remained a group of shops that sold cake and tea. Analysing the company should have been easy. It operated in a homogenous market: the UK and Ireland. It didn’t use complex financial instruments to manage risk. It financed its operations with equity and bank overdrafts. It had a real presence: you could visit its cafés, speak to its suppliers, and check in with landlords.

Time and again shareholders gave the same reasons for investing: it’s a simple, nimble, cash-generative business. “It sells things that everyone can understand,” said Chris Boxall, who invested in the company personally and through his firm Fundamental Asset Management.

Paul Mumford, who owned £2m of Patisserie Holdings in his Cavendish Asset Management fund, said that “it looked as though it had a strong balance sheet, decent trading record, decent management, and was relatively marketable.

“Then of course all those things turned out to be untrue.”

Investors saw a simple business and a well-known director with a large stake. It was a no-brainer. Johnson’s large shareholding, they thought, overcame the principal-agent problem in which a business owner – the principal – has a stake, but its manager – the agent – doesn’t.

The popular stock-picker website Morningstar wrote, eight weeks before the news of the fraud broke, that Patisserie Holdings is a “company that has a high-quality management team that own significant stakes in the business”, adding that “[it] makes and sells cakes, pastries, snacks and other food items from these outlets”.

Stephen Clapham is a company analyst at Behind the Balance Sheet, who cut his teeth at multibillion-dollar hedge funds. Hindsight is a wonderful thing, Clapham knows, but a cold, hard look at Patisserie Holdings is all investors needed to see the warning signs. “There was nothing that would lead you to think it was a fraud, but a lot should have warned against investing in the company.” Clapham found two facts stood out in particular.

First, Patisserie Holdings was trading at around twice the valuation of its peer group on a per outlet basis: a £2.8m valuation per outlet compared to, say, £1.4m per outlet for Restaurant Group. This is anomalous, given their respective sales-per-outlet figures. Restaurant Group outlets, which include the brands Garfunkel’s, Frankie & Benny’s and Wagamama, made an average of £2m in sales per outlet compared to Patisserie Holdings’ £0.6m.

Second, Patisserie Holdings reported operating profit margins of 18 per cent, compared to 9 per cent for the industry. Its margins, Clapham found, were close to coffee chains Starbucks and Costa. “Coffee is an extremely high margin product,” Clapham said. He found that stores like Starbucks make a 71 per cent gross profit per cup. “The idea that a cream cake business is more profitable than a coffee one is absurd. Cream goes off. Coffee gets taken out. Starbucks doesn’t need many tables and chairs, or any chefs.”

Clapham’s argument is striking. A 20-minute analysis is all it took to uncover these simple truths. I ask how and why no one else did this. “It’s hard to say, but I think people just backed the man.”

For all the excitement about Patisserie Holdings, few people were asking the right questions. Start with Johnson, whose business pedigree and one-third shareholding attracted many investors to the company. I asked Boxall whether he feels there’s anything that he should have spotted. “The one issue we should have noticed was Mr Johnson, who was the main reason we had confidence in the business,” Boxall said.

“He had too many business involvements,” Boxall added. “He was proud of them but lost touch entirely.”

Dave M. Benett/Getty Images

Luke Johnson in London in 2007

The celebrity chairman

Johnson told the BBC in 2003 that he prefers being called a “projector”: a 17th-century term for a man involved in many businesses (many projects make you a projector). At the time, Johnson was already running a number of businesses, including the nationwide chain Pizza Express. Even now, it is this chain that is most closely associated with Johnson.

He concluded the interview with some words of wisdom for budding entrepreneurs: “Concentrate more – I could be accused of being slightly dilettante.”

Johnson went on to take over a number of casual dining businesses through his firm from that point on. The writer Will Self called him the “Führer of mid-price British restaurant dining” in the New Statesman, a magazine once edited by Paul Johnson, his father and a respected historian.

But Johnson’s march was by no means pre-determined. The story Johnson tells is that he became an entrepreneur purely by accident. With a friend, he organised student parties at Oxford University where he studied medicine. The BBC interview says that Johnson graduated in 1993. Johnson, in fact, never graduated – a fact he now acknowledges – and left university to work as a company analyst in the City.

While in the City, he moonlighted in a series of pubs and software firms that eventually led him to Pizza Express in 1990. He joined the chain two years later and floated it a year after that. The interviews followed, as did the business books, and a Sunday Times column.

His writing is pugnacious and full of business analogies. A month before the Brexit referendum, Johnson, a proud Leave voter, wrote: “[as] a businessman, I know the importance of keeping on top of costs… EU regulation costs businesses in the UK £600m every week.” Patisserie Holdings’ last annual report listed “the Brexit vote and the uncertainty surrounding Brexit strategy”, which inflated ingredient prices, weakened the pound, and so sharply increased costs, as a principal risk for the company.

A month before news of the fraud broke, Johnson’s Sunday Times column was headlined: “A business beginner’s guide to tried and tested swindles.” The column is an itemised list of 12 ways in which fraud can be spotted. In his words, it is “an aide-memoire for those looking to spot the next fraud… Surprisingly, very little changes – many of the same tricks were played 50 or even 100 years ago.”

When news of the fraud first broke, Johnson was listed as a director of 35 British companies. He then promised shareholders that he’d scale back his holdings. Since October, he has resigned from six companies and dissolved another two.

The time a director should spend on a company varies according to the nature of the business and the director’s role. Casual dining is a demanding industry and Boxall emphasised that Johnson’s role at the company was “executive chairman”. He was also chairman of the remuneration committee. And a member of the audit committee. A McKinsey report claims that “if a potential director can’t put in 300 to 350 hours a year, she shouldn’t take the job”.

For Johnson’s 35 appointments before October this would add up to between 10,500 and 12,250 hours a year – or 1,740 to 3,490 more hours than there are in a year.

One organisation did raise the alarm about Johnson’s over-boarding, but in relation to another company. In February 2018 Institutional Shareholder Services, the world’s largest shareholder advisory, told Elegant Hotels plc shareholders to vote against the re-election of Johnson to the company’s board. The UK Corporate Governance Code doesn’t limit the number of board positions a director can hold, but ISS warned that Johnson’s other directorships “could compromise his ability to commit sufficient time to his role in [Elegant]”.

Johnson was re-elected anyway and wrote about the experience in a furious Sunday Times column headlined, “Bungling, box-ticking hypocrites who tried to kick me off a board”. Criticising corporate governance advisers throughout his column, Johnson wrote: “Perhaps before lecturing others, they should put their own houses in order.”

ISS highlighted Johnson’s position as chairman of The Brighton Pier Group plc as a time conflict. Brighton Pier put out a profit warning at the start of 2019. Grant Thornton audits the company. Bread Holdings, the parent company of Gail’s Bakery, another fast-growing chain of cafes chaired by Johnson, experienced a 93 per cent drop in profits last year. Elegant Hotels, meanwhile, “is another one that’s got a lot of debt and has questionable valuations around its assets”, Boxall warned.

An overstretched director may be unable to cope with additional issues or may think they are responsible only for the things where they can be shown to have direct personal knowledge. In that case, there are disincentives to acquire formal knowledge and an over-reliance on other directors develops.

“Do you know”, Scott asked about the pub chain owner Tim Martin, “how many directorships he has?” One: his JD Wetherspoon’s chain.

The directors

No one who I spoke to suggested that any of the directors were stealing company money. As Scott said: “I don’t think that Marsh spent four years pocketing £40m, then sat down in his living room in St Albans to wait for the SFO to knock on his front door.”

Johnson was the only one of Patisserie Holdings’ five directors who didn’t sell off company shares ahead of its trading suspension. Marsh and May both made two transactions – the first 35 weeks from the trading suspension and the second 11 weeks – earning them, respectively, £1.9m and £2.6m.

The share options were granted to Marsh and May as part of their long-term incentive plans, exercisable from July 2017 conditional on share price performance. Profit figures growing each and every year, which we now know are unreliable, drove that performance.

There was nothing unlawful in the directors being allocated or exercising their share options, but two weeks after its collapse the company released a statement saying that it is “seeking to understand” why the grants of share options “have not been appropriately disclosed and accounted for in its financial statements”. May and Marsh were issued twice the number of shares it disclosed in official filings.

James Horler, non-executive director, also sold £173,000 worth of at the same time. Lee Ginsberg, non-executive deputy chairman, senior independent director and audit committee chairman, sold £187,000 worth of shares 14 weeks from the trading suspension.

There were only two other episodes in which directors sold off shares in Patisserie Holdings. On June 15 2015, a year after the company went public, Johnson, May, Marsh, and Horler all sold shareholdings worth a total of £15m in gross terms. Two days later, Marsh and Horler sold £159,120 and £458,640 worth of shares to “satisfy market demand for shares”.

It is common for directors to cash in on their shareholdings soon after an IPO; firms usually specify share lock-up agreements that keep insiders and other pre-IPO shareholders from selling their shares for around a year after IPO. It is harder to explain the share sales in the weeks running up to news of the fraud.

It will be some time before the full picture of what happened at Patisserie Holdings since 2014 emerges. We know some details leaked from the report by the forensic accountants who are now poring over the company’s books: multimillion-pound cheques submitted shortly before the financial year-end would temporarily inflate the company’s cash position but then bounce; the company had overdraft facilities and two current accounts, allegedly unknown to the directors, in which £9.7m was run up. Opening bank accounts for a company normally requires director approval.

The auditors

There’s one class of people who should have noticed Patisserie Holdings’ problems – in fact, were paid to notice them: the auditors. They sample transactions, Clapham said. “There were thousands of false transactions. They must have found at least one.” And it wasn’t just the company’s own auditors who have questions to answer, but its independent auditors at Grant Thornton, and the Financial Reporting Council, which was founded by and regulates the audit profession.

In Patisserie Holdings, Lee Ginsberg chaired the audit committee until his resignation five days before the collapse. Ginsberg chaired audit committees at four other public companies at the time. The committee had two other members: one also resigned shortly before the collapse and the other was Johnson. According to a 2017 report, its primary responsibility was “monitoring the quality of internal controls and ensuring that the financial performance of the Group is properly measured and reported on”. The committee reported no wrongdoing over the course of the fraud.

Grant Thornton audited Patisserie Holdings’ financial statements over the same period. In its last audit, Grant Thornton found that the statements gave “a true and fair view” of Patisserie Holdings’ finances and that they were prepared in accordance with industry standards and English law. Grant Thornton responded to a request for comments with: “We owe duties of confidence to Patisserie Valerie in respect of our audit work.” Patisserie Holdings dismissed Grant Thornton as auditors shortly after the fraud was uncovered, but struggled to appoint new ones, only managing to do so a week before the collapse.

Perhaps you get what you pay for. Patisserie Holdings paid Grant Thornton £18,000 to audit the group accounts. That’s £9,000 less than the salary of an entry-level auditor at Grant Thornton. In general, senior auditors bill at £1,000 per hour, juniors at £500 per hour.

With the £18,000 worth of audit time for Patisserie Holdings’ group accounts, Grant Thornton says it audited the consolidated statement of comprehensive income, the consolidated balance sheets, the consolidated statements of changes in equity, the consolidated statement of cash flows and notes to the consolidated financial statements, including a summary of significant accounting policies. Audit fees for the group accounts are static over the company’s life on the stock exchange; fees for its subsidiaries grew slightly in the final year, despite growth in revenues.

Johnson’s other public company, the Brighton Pier Group, made revenue of £31.7m in 2017 compared with Patisserie Holdings’ £114.2m. Despite being a business a fraction of the size of Patisserie Holdings, the Brighton Pier Group spent eight times as much on Grant Thornton’s group accounts audit.

Perhaps the size of payment wouldn’t have mattered at all. Grant Thornton’s chief executive David Dunckley went in front of parliament’s Business, Energy and Industrial Strategy (Beis) Select Committee on January 30, which grilled him about Patisserie Holdings. Dunckley told the committee: “We’re not looking for fraud, we’re not looking at the future, we’re not giving a statement that the accounts are correct.” What, then, are they doing? “We are saying [the accounts are] reasonable, we are looking in the past and we are not set up to look for fraud.”

The Financial Reporting Council is now investigating Grant Thornton’s audits of Patisserie Holdings. But don’t hold your breath. In January it emerged that the Council’s audit quality review team, whose purpose is monitoring and promoting “continuous improvements in audit quality in the UK”, gave Grant Thornton’s 2017 audit a clean bill of health as part of its review of auditing work from a sample of businesses.

Some shareholders said that they think auditors should have noticed Patisserie Holdings’ problems, but they understand why they didn’t. The audit profession, they say, has changed. It no longer involves detailed on-the-ground analysis of a company. It’s now about high-level quantitative analysis of company’s financial data, done by young and inexperienced teams.

Prem Sikka, an accounting professor at Sheffield University, who was asked by the Shadow Chancellor to lead a review into the audit profession, is less kind. “There are so many ways that you could have detected the problems,” he says.

The Financial Conduct Authority is now investigating Patisserie Holdings’ bankers, HSBC and Barclays, over two previously secret overdraft facilities that were used to run up £9.7m. I asked Sikka whether he thinks the auditors could have detected this. Yes, he said: “They could have written independently to the banks: could you please tell us how many accounts there are?”

With such high profit margins compared to the industry, Sikka says, the auditors should have been asking: “Are the sales overstated? The costs understated? You can write to creditors to confirm these things.” Debtor numbers may have been falsified. “Auditors have to write to major debtors and say tell us what you think the balances are.”

“There are numerous procedures,” Sikka says, “it’s just that auditors don’t apply them.”

Suing auditors is generally difficult because of the legal principle of joint and several liability. If for example a director fraudulently misstates a company’s financial statements, the board fails to detect this because of weak oversight, and the auditor performs a poor audit that leads to a wrong opinion, joint and several liability says that all three parties are at fault. Shareholders seeking damages for any resulting losses can only try to recover losses from one party. They are considering it.

Philip Rubens, a partner at Teacher Stern with expertise in group litigation, has signed on Patisserie Holdings’ institutional shareholders to seek damages against the company “and possibly others”. The focus, he says, is “on a fraud committed by someone at senior management level and the inaccurate statements made by the company in relation to its announcements”. Rubens is seeking the forensic accountants’ report into the fraud. Any potential action would take years.

Meanwhile Johnson is reportedly considering legal action against Grant Thornton, but the key question, Sikka says, is: “Was there contributory negligence from the director? Grant Thornton would say, ‘OK, we have been negligent but so were you’ and the damages would be minuscule.”

Daniel LEAL-OLIVAS / AFP)

The end?

There was a very brief moment when Patisserie Holdings thought it could turn things around. It appointed a new chair to its audit committee, Jeremy Jensen, who is a specialist in crisis management and corporate turnarounds; and a new CEO, Stephen Francis, who Johnson described as having “a strong track record of restoring value in turnaround situations”.

Accountants from PwC were brought in to conduct a forensic analysis of the company’s accounts. Accountants from KPMG were brought in to advise on the company’s recovery. RSM, the new auditors, said they were working towards a restatement of the company’s accounts. At a company meeting in November 2018, Johnson provided a £10m, three-year interest-free loan and a further £10m bridging loan for immediate liabilities. The company raised £16m through the issue of new shares. People were clearly upset – one shareholder said he wanted the company to “go to hell” – but most still apparently believed in Johnson’s ability to turn it around.

But the hole was too deep and in any case these actions were based on the belief that people would trust Patisserie Holdings and its directors in the same way that they did before its trading was suspended. What would have happened had trading re-opened? It’s hard to imagine that investors would have piled in rather than run out. The largest among them are gearing up for group litigation. It’s difficult to believe that suppliers would have returned to the company or that the auditors would have been able to build up a credible picture of its true position.

It all hinges on that one thing that auditors are meant to engender: trust. But as Sikka told me: “If we could trust company directors to act in an honest way, then we wouldn’t need an auditor in the first place.”

What next for Patisserie Valerie? Its administrators are looking for buyers. Sources say Johnson may try buy the remaining stores. Meanwhile Scott is looking for partners to submit a bid. He ran off to meet his corporate lawyers after our meeting, asking me two hours later for Robert Scalzo’s contact details. “I’d like to take one or two of them back,” Robert had told me when we met. “Give David my email.”