High and Dry: Retailers count the cost of private equity ownership

Steve McLinden/Shopping Centers Today - Retail chains under the ownership of private equity firms are declaring bankruptcy and liquidating at an alarming rate, as the practices of high-leverage borrowing and equity stripping make it harder for vulnerable retailers to turn around. “If you look at the record of private equity in the retail industry, it is appalling,” said retail analyst Howard Davidowitz, chairman of Davidowitz & Associates, a New York City–based consulting and investment banking firm. “Retailers that accept one of these deals in this environment are almost certain to go bankrupt.”

Of the 43 large retail companies owning chains of 10 or more stores and that have filed for bankruptcy since January 2015, private equity firms owned 18, according to news reports. “Most times these private equity companies still make out through giant fees and other payments they get, despite the company collapsing around them,” Davidowitz said. “They are a disaster.”   

Indeed, a Fitch Ratings study of 30 retail bankruptcies dating back a decade found that about half of them ended in liquidation, versus only 17 percent across other industries. And some observers note that factors like mounting debt maturities, supplier squeezes, operational missteps, overdue interest and lackluster online stores have already begun to push struggling retailers to the brink of bankruptcy, even apart from any involvement of private equity firms. “Any retailer that is not selling customers what they want and has an inappropriate capital structure is destined to fail,” said Brad M. Hutensky, founder and CEO of Hartford, Conn.–based Hutensky Capital Partners. “I don’t think the type of ownership alters that fact.”

Private equity companies, also known as leveraged-buyout firms or financial sponsors, generally acquire retail chains by contributing small amounts of cash toward the purchase price and borrowing the balance. They use the real estate of these target companies, which assume responsibility for repaying that debt, as collateral.

Among the retailers that have gone bankrupt under private equity ownership are Aéropostale, A&P, Bob’s Stores, Eastern Outfitters, Gymboree, Gordmans, The Limited, Pathmark, Payless ShoeSource, Rue21, Sports Authority, True Religion, Waldbaum’s and Wet Seal.

Gymboree, which is in the process of closing 450 of 1,300 stores worldwide, filed for Chapter 11 bankruptcy protection in June. The company says it continues to struggle with debt from its October 2010 buyout, when Bain Capital took the chain private for $1.8 billion, including $524 million in equity. In court filings, Gymboree outlined plans to improve its online store to compete with peers Gap and The Children’s Place. Gymboree’s unsecured creditors, for their part, have said in court filings that they are considering claims against Bain and other insiders.

Payless and its creditors have complained that the hundreds of millions of dollars in debt it assumed through the private equity ownership of Golden Gate Capital and Blum Capital led to the discount shoe chain’s financial collapse. Meanwhile, struggling luxury retailer Neiman Marcus says a sizable chunk of debt from its $6 billion leveraged buyout in 2013 by Ares Management and Canada Pension Plan Investment Board from other private equity companies is frustrating its attempts to right the ship, according to published reports. A term loan of nearly $3 billion is slated to come due in 2020. Neiman Marcus, which has struggled with problems on its e-commerce site, backed out of an IPO filed in 2015.

Another private equity company, Sycamore Partners, is acquiring Staples for about $6.9 billion, paying $10.25 a share, a 12 percent premium to its June 27 price when news of the acquisition broke. To help fund the takeover, Sycamore is dividing the office-supply chain into three separately financed units. About 60 percent of Staples’ revenue comes from online orders, according to GoodHaven Capital Management, which owns 1.2 million shares of the chain.

Davidowitz says private equity companies tend to seek out retailers they perceive as undervalued, then look to remove costs by cutting facilities and employees, but fail to devote sufficient funds to branding, digital operations and other key areas.  “They’re loading up these chains with debt and leaving them with no way to go but down,” said retail consultant Jeff Green, proprietor of an eponymous firm in Phoenix. “Private equity obviously doesn’t know how to operate a retail company.”

Muddying the situation is an accounting method that no longer requires fund investors participating in private-equity buyouts to pay for their shares when a deal is struck. The private equity firms instead tap so-called subscription credit lines to complete the buy and only later ask for investor money. This practice tends to inflate funds’ annualized results, wrote Howard Marks, co-chairman of Oaktree Capital Management, in a company newsletter. The practice can also be gamed to increase fee payments to general partners, Marks wrote.

In its Global Private Equity Report 2017, Bain & Co. says private equity firms have not had time to adjust their acquisition models because the retail industry has changed so rapidly. Often overlooked are retail price erosion, cost inflation, capital expenditures, reinvestment costs and the need to respond rapidly to changing product mixes. “Companies in fast-moving consumer goods or fashion retailing, for example, have to contend with sudden shifts in consumer taste that can reshuffle their product mix in a matter of months or weeks,” reads the report, which notes that the need to ramp up marketing programs to increase revenue is overlooked too. Though private equity managers are unable to predict every industry shift, “they can anticipate the risk through a version of scenario planning that lays out a best and worst case for each product line,” the report says.

Defenders of private equity acquisitions say these investors have a history of providing long-term capital to transform acquired companies into healthier businesses. Many large institutional investors, including CalPERs and TIAA (formerly TIAA-CREF), actively invest in private equity funds. TIAA, in fact, has done so for two decades, a strategy that “provides access to illiquid investments that historically have generated attractive risk-adjusted returns,” according to its website. Such co-investments offer “unique investment opportunities alongside experienced private equity fund managers,” the organization said.   

For a long time, retail executives deliberated the complexities of operating as a public company, Green says. “Now they talk about the challenge of being a private company.” To be competitive “you’ve got to have adequate dollars available to pay people to keep you up and running,” he said, “and these companies aren’t getting that under private equity ownership.”

So why do the CEOs, shareholders and other company officials of struggling companies consent to private equity takeover? Many times the top executive is offered a bonus, and shareholders are offered a substantial stock premium and unusually generous dividends, notes Davidowitz. “The CEO says to himself: ‘How can I turn this down? I am supposed to be working for the shareholder.’ And it’s all done with borrowed money, of course,” said Davidowitz. The net result is often liquidation, he says.

Deal scenarios change when a family owns a retail company, as is the case with Nordstrom, says Davidowitz. At press time Nordstrom family members were in talks with potential private equity partners that include Apollo Global Management, KKR & Co. and Leonard Green & Partners to take the luxury chain of 354 stores private. Family-held retailers are less likely to accept risky deal structures, because the decisions are shared among the family members, who usually want to ensure the company’s survival as a legacy, says Davidowitz.

Too many struggling and bankrupt retailers simply failed to adjust their business models fast enough to accommodate meaningful e-commerce trade, Hutensky says. “As the announced purchase of Whole Foods by Amazon demonstrates, online-only retailers have embraced the necessity of the brick-and-mortar stores as a part of any retail strategy,” Hutensky said. “Successful retailers are providing their customers with a great experience both online and in the store.”

More bankruptcies are coming, many say, particularly if the retailers turn to private equity. “In the past seven years or so,” said Green, “private equity has gone from turning retailers around by cutting expenses to using creative debt financing when they saw a lot of these retailers weren’t going to make it.”