Private Equity Racks Up Checkered Record in Retail Buyouts (6/29)
Jun 29, 2009 1:21 PM, By Elaine Misonzhnik
Winners and losers
Back when credit was readily available, underperforming retail chains were an attractive target for private equity players because they offered a high potential for profit at little cost. Private equity firms usually amass vast portfolios of firms in different sectors because their whole business model is based on risk, notes Hooper. In order to win multibillion-dollar bids for national retailers like Linens 'n Things or Dollar General, they secure short-term acquisition loans that can account for anywhere from 40 percent to 90 percent of the acquisition price. The higher the leverage level, the more acquisition power the firm has. KKR, for example, owns a stake in Toys 'R' Us, bedding manufacturer Sealy Corp., real estate finance firm Capmark Financial Group and many others, in addition to its ownership of Dollar General.
The financing is usually secured by the assets of the firm to be acquired and is meant to be replaced by permanent loans a few months down the road. The new owners then attempt to capitalize on their holding companies by either cutting operating costs, or improving profit margins for the underlying business; in some cases, both. Once the turnaround is completed, in two or three years' time, the company is returned to the public market through an IPO, generating additional profits for the private equity players.
The risk attached to this sort of play has to do with the financing model, which backs acquisition loans with low investment grade bonds and features high-interest payments that can destroy the acquired firm if the turnaround strategy is not successful. Moreover, with sky-high debt-to-equity ratios leveraged buyouts can turn disastrous if private equity players can't refinance their loans. That problem has materialized in August of 2007, when the credit crisis first hit the U.S. and it continues to be a pressing concern. According to Standard & Poor's, between 2010 and 2014, more than $476 billion in LBO loans will reach maturity. But even without accounting for the current credit shortage, in recent years, the annual leveraged loan issuance has averaged only $104 billion.
The breakdown of which retailers are headed for extinction and which will ultimately survive the carnage will depend in large part on how strong the core retail business was at the time of the buyout, says Hooper. "If you think about the guys that are struggling now, most of it is fundamental problems with their model that were accelerated by the debt they've taken. There wasn't enough time to turn them around" before the downturn hit.
The good news is that there appear to be some outperformers among the bought-out retailers, including Dollar General, J. Crew and Toys 'R' Us. For example, for the first quarter ended May 1, J. Crew Group, Inc. reported that total sales rose 5 percent, to $240 million and revenues increased 2 percent, to approximately $346 million, though same-store sales declined 2 percent compared to the first quarter of last year. The performance is impressive given J. Crew's position on the more expensive side of the specialty apparel sector, one of the more challenged sectors in this economy, notes James C. Bieri, president and CEO of Detroit-based consulting firm the Bieri Co. J. Crew, which is headquartered in New York City, is partially owned by Texas Pacific Group.
Meanwhile, toy seller Toys 'R' Us, Inc., which is owned by KKR, Bain Capital and Vornado Realty Trust, has been slowly getting ahead by cutting operating expenses and gaining market share by eating up its competitors. In May, for example, it signed a contract to buy upscale rival FAO Schwarz for an undisclosed sum. Other purchases have included eToys.com, Toys.com, babyuniverse.com and ePregnancy.com.
For the first quarter ended May 2, Toys 'R' Us reported a 5.4 percent drop in same-store sales compared to the first quarter of last year. The retailer's gross margin, however, remained the same, at 35.9 percent.
On the flip side, consider Linens 'n Things, which was picked up by Apollo Management Ltd. and National Realty & Development Corp. (NRDC) for $1.2 billion in 2006. The chain always trailed rival Bed, Bath & Beyond in the big box home furnishings sector, notes Johnson. In recent years, discounters Target and Wal-Mart have also crowded the home furnishings field. So when the housing crisis drove down Americans' furniture and housewares purchases in late 2007 and early 2008, the Clifton, N.J.–based retailer found it couldn't compete. In May 2008, Linens 'n Things was forced to file for Chapter 11 bankruptcy, with initial hopes of restructuring as a leaner, more profitable operation. As of year-end 2007, the company faced $1.42 billion of debt, against assets worth $1.74 billion. In June 2008, the bankruptcy court approved Linens 'n Things for $700 million in debtor-in-possession (DIP) financing from the GE Capital Corp. Given the market environment, the firm was lucky to secure a DIP loan—with many financial firms on the verge of ruin, DIP financing has been scarce in this recession.
By October, however, the company's owners were forced to begin liquidation proceedings as sales continued to plummet and the chain faced mounting pressure from bondholders to pay back debt. In the aftermath of the liquidation, the retail real estate market was flooded with hundreds of vacant big boxes. (As of October 2008, Linens 'n Things operated 371 stores.)
The fallout in retail has hit all sectors. Sales of electronics, furniture, apparel, books and accessories have plummeted as the world faces the worst recession in 80 years. In November of 2008, the Deloitte Consumer Spending Index turned negative for the first time since 1980. Since October of last year, U.S. chain stores have had 10 consecutive months of same-store sales declines, according to ICSC. From January through April, same-store sales have fallen by an average of 0.5 percent, compared to a gain of 0.9 percent in 2008 and 2.1 percent in 2007.
As a result, even chains that were previously considered well managed and recession proof have suffered. For example, luxury department store operator Neiman Marcus, Inc., which was bought by Texas Pacific Group and Warburg Pincus for $5.1 billion in May of 2005, has often been lauded for the management savvy of its president and CEO Burton M. Tansky and executive vice president Karen W. Katz. Since the buyout, the chain attempted an expansion campaign, opening new Neiman Marcus stores, launching the boutique clothing concept Cusp and planning to gradually enter smaller markets. In addition, until the stock market meltdown of 2008, luxury sellers were thought to be one of the safest sectors in the industry, since recessions tend to have less of an impact on the shopping habits of the very wealthy than on those of the middle class. But for the second quarter of 2009, ended Jan. 31, Neiman Marcus reported that its total sales declined 21 percent, to $1.08 billion from $1.37 billion a year ago, and its same-store sales fell 22.8 percent. The retailer ended the quarter with an operating loss of $529.7 million.
"I don't think you will see Neiman Marcus go belly up, but they might close stores," says Hooper.
The Dallas-based company currently operates 40 Neiman Marcus stores and two Bergdorf Goodman locations. At the time of the buyout, the retailer operated 35 Neiman Marcus stores and two Bergdorf Goodmans.
Another retailer that might find itself on the verge is PETCO, which was bought by Texas Pacific Group and Leonard Green & Partners for $1.8 billion in 2006. The two firms already had plenty of experience with the retailer after having bought it in the fall of 2000 and sold it back into the public market two years later. By 2006, however, the San Diego, Calif.–based pet food and supplies seller was less popular with consumers than sector rival PetSmart, according to Johnson. Adding to the pressure now is the fact that as Americans continue to lose jobs and watch their life savings disappear, many are less inclined to pamper their pets with premium products. Instead of shopping at a specialty pet store, they are going to discount stores like Wal-Mart and Dollar General, says Johnson.
The fates of accessories seller Claire's and department store chain Sears also remain doubtful. For the fourth quarter ended Jan. 31, the most recent period for which financial information is available, Claire's Stores, Inc. reported a net sales decline of 12.2 percent, to $393 million, and a same-store sales decline of 7.2 percent. For the first quarter ended May 2, Sears Holdings Corp. reported a 7.4 percent decline in domestic same-store sales compared to the same period last year and a gross margin of $2.9 billion, down 3 percent from $3.0 billion in the first quarter of 2008. Claire's and Sears are owned by Apollo Management, L.P. and hedge fund ESL Investments, respectively.
Continue: "Real Estate Pipe Dream" and "Too Much Risky Business"...
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