Private Equity Racks Up Checkered Record in Retail Buyouts (6/29)
Jun 29, 2009 1:21 PM, By Elaine Misonzhnik
When Kohlberg Kravis Roberts (KKR), the legendary New York City-based private equity player, purchased the discount retailer Dollar General for $7.3 billion in July of 2007, the deal hardly made waves. Although it was one of the largest private equity buyouts in the retail sector, it came at the tail end of a four-year stretch in which deals with billion-dollar price tags were the norm. During that time, retailers of all types, including Albertsons, Neiman Marcus, Michaels Stores, Burlington Coat Factory, PETCO and Toys 'R' Us, fell into the arms of private equity buyers. In 2006 and 2007, there were 91 leveraged buyouts of retailers in the U.S., totaling more than $48 billion. By contrast, in 2008, there were 24 buyouts totaling less than $1.2 billion.
Yet two years later, the Dollar General deal stands out as one of the few true success stories from that buying binge. With its focus on budget shoppers, the retailer has withstood the recession better than most. Moreover, from the start, the deal was a retail play—not a real estate bet in disguise, as many other buyouts have proven to be.
"Dollar General has been a real home run," says Craig Johnson, president of Customer Growth Partners, a New Canaan, Conn.–based consulting firm. "That's where the retail market and the wholesale migration toward value players have very much worked in favor of the company."
For its fourth quarter ended January 30, Dollar General reported net income of $81.9 million, 47.8 percent higher than the $55.4 million reported in the fourth quarter the year prior. Total sales during the period rose 11.2 percent compared to 2007, to $2.85 billion. Same-store sales increased 9.4 percent. In April, as thousands of companies around the country continued to lay off workers in order to stay afloat, Dollar General announced a plan to create 4,000 new jobs in 2009 to support an additional 450 stores. Last year, the retailer opened a net of 168 new stores.
To KKR's credit, the firm says it bought Dollar General because it thought a downturn was coming before the credit crisis hit in September, although it did not think the damage would be of this magnitude. "I think it's fair to say that the downturn in consumer spending was greater than anybody anticipated," says Mike Calbert, KKR's partner in charge of Dollar General. "Clearly we didn't think that the level of consumption [we had] was sustainable, just given the lack of savings, the leverage level the consumer was getting to. We thought there was going to be a pullback, but the reality of the ... worst fourth quarter in 40 years of retail history wasn't something that we anticipated."
Still, the deal was a bet that discount chains would become more popular during a downturn—a bet that has paid off in spades. In addition, the fact that Dollar General leases all of its stores, rather than owning them, might have made KKR less focused on getting value out of its real estate holdings and more focused on improving profit margins for the core operating business.
Overall, though, the Dollar General story is an exception to how things have played out for private equity buyouts. The combination of a tightened credit market, a fall in real estate values and a pullback in the retail sector has dealt crippling blows to many buyout targets. Back in September of 2006, private equity players were preaching the message that they'd learned their lessons from the wave of disastrous leveraged buyouts of the 1980s. This time they would saddle buyout targets with less debt and pour more resources into what they thought were undervalued retail companies. And even if things didn't turn out well, they saw a potential safety net in the value of real estate many firms held. In fact, analysis of some companies during the height of the boom showed the value of underlying real estate to be greater than market capitalization of the entire firm. That made the buyouts no-brainers.
But the reality has turned out much different. The recession and the accompanying credit crisis have proved too much to handle for a number of buyout targets. The precipitous decline in consumer spending has made it difficult to make money on core operating businesses, especially given that many of the bought-out chains were secondary or tertiary players in their respective sectors, according to Todd Hooper, principal with Kurt Salmon Associates, a global management consulting firm. Debt has also been an issue. Many of the deals were financed with short-term acquisition loans, which were meant to be eventually replaced with permanent financing. But private equity firms have had trouble getting permanent loans since late 2007. Meanwhile, the precipitous drop in real estate values and spiking vacancies in the retail sector took away the new owners' supposed safety net.
As a result, many of the chains that were viewed as undervalued steals in 2005, 2006 and 2007—Linens 'n Things, Fortunoff, Mervyns—are now defunct following a series of painful liquidations. And we're likely to see more privately held retailers join their ranks, says Johnson.
"We believe the economy is near the bottom now, but don't see a big turn till next year," he notes. "And the [leveraged buyouts (LBOs)] tend to be over-leveraged and not have a strong capital base. We think it's more likely than not that we will see additional Chapter 11 [filings] and some direct liquidations. We haven't seen the last of it by any means."
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