Flush with cash, but fearful of not making returns on it, or worse, having to give the money back, the hedge funds as well as the private equity investment firms are taking keen interest in the retail and fashion segments.

Private equity players are trolling the sector for acquisition targets while the hedge funds are upping their investment stakes. But it’s not all wine and roses. This intensified interest in retail and fashion is changing the dynamics of the business, and some analysts predict diminishing returns for all investors as a consequence of this investment trend.

But with nearly $120 billion to invest, the hot fashion and retail sectors seem to be anything but a passing fancy to the hedge funds and private equity players. And for the retailers, designers and suppliers that are the targets of their investments, it’s hard to resist a cash boost from the big cats with their fat wallets.

“If you want to know why retail is the flavor of the month, look to Edward Lampert,” said Howard Davidowitz, chairman of Davidowitz & Associates Inc., a national retail consulting and investment banking firm.

Lampert, chairman of ESL Investments, engineered the Kmart-Sears merger earlier this year, less than two years after bailing out the discounter from bankruptcy proceedings in 2003.

Hedge funds get their name from the ability to utilize different investment strategies to “hedge” against market downturns, sometimes using return-enhancing strategies such as leverage, derivatives or arbitrage. The funds provide an alternative to investors seeking capital appreciation and even capital preservation during bear markets.

But as the funds have become flush with cash, they’ve definitely taken a keener interest in retail, and nowhere is this more evident than in the trading volume around the monthly same-store sales reports.

“I think that the hedge funds are making it a difficult chore for retailers to meet those monthly expectations that sometimes aren’t possible. Retail operates more on a long-term horizon, with companies generally hoping to meet their goals through internal growth and acquisitions,” observed Walter Loeb, a former retail analyst and now consultant at the firm that bears his name.

Loeb views much of the hedge fund trading activity as a potential negative for retail.

This story first appeared in the May 16, 2005 issue of WWD. Subscribe Today.

“Monthly sales give the stores a visibility and investors understand the year-to-year basis. However, if you start pushing for monthly sales for the sake of getting the comps numbers up, you’re also destroying the natural evolution of the company.” said Loeb.

An investment relations executive at a specialty retailer also has noticed the increase in hedge fund activity, both the frequency in phone calls from investors seeking information and the volume of shares changing hands in the days before and after comps are posted.

“It is interesting that while the hedge funds represent less than 10 percent of the overall equities market, at the same time they make up over 25 percent of the trading fees for the large Wall Street firms. Their presence totally changes the dynamics of the landscape,” said the executive.

He explained that the intense focus can be good for retail stocks since a higher trading volume sometimes correlates with an increase in firm visibility. Still one possible negative down the road for firms that track retail performance might entail a sector move away from monthly guidance to quarterly comps as firms try to steer investors toward the longer-term outlook, he noted.

William Susman, president and chief executive officer at investment banking firm Financo Inc., cautioned, “One of the challenges for both hedge funds and private equity firms is that as there are more entrants, you’ll start to see a compression of returns.”

Creating a point of differentiation is one area where firms can increase their likelihood of attracting the better deals, as well as provide more value to the retail and apparel transactions that they do take part in, the investment banker noted.

Bear Stearns Merchant Banking is one example of a firm that has been able to differentiate itself from the others, focusing more on long-term value than just the immediate purchase price, Susman points out. He added that Apax Partners Inc., with its focus on retail and consumer companies particularly after its merger with Saunders Karp & Megrue, and Mercantile Capital Partners, an independent private equity fund focused on retail and consumer companies in which Financo is an investor and at times adviser, are other examples.

Surely, the increased focus on retail and apparel firms has also meant more opportunities for many executives to stretch their wings following their usual stints at the top management ranks. Robert DiNicola, former chairman and chief executive officer at Zale Corp., is now retail adviser to leveraged buyout firm Apollo Advisors. Vanessa Castagna, former chairman and ceo of the J.C. Penney Stores, was tapped by Cerberus Capital Management to oversee the firm’s investment in Mervyn’s.

Hal Reiter, chairman and ceo at executive search firm Herbert Mines Associates, placed Castagna at Cerberus. He said, “The private equity firms have to put their money to work, and retail and apparel is one of the places where that money can work. In order to do it, they need executives to help them evaluate possible investments and run the companies they invest in. Vanessa was hired to serve both roles, helping to run Mervyn’s, as well as assessing other acquisition opportunities.”

According to Reiter, some of the private equity firms won’t consider an investment unless there is already a management team in place or someone the firm can tap once the deal closes.

“Some of the valuations suggest a bubble [on pricing], but there’s also so much money out there and you have many firms chasing the same deals. I think the focus on retail and fashion will continue for the foreseeable future. They’re industries that people feel they understand. They’re a bit sexy, and while fashion can be risky, retail is not as volatile as some of the industries,” observed Reiter.

The going may be good for now, but there are clouds on the horizon. “We’re looking at stormy times for the economy, with a possible slowdown for retail stocks as consumers are faced with higher energy costs and other inflationary factors,” cautioned Loeb.

According to Louis Bevilacqua, a partner at the law firm Cadwalader, Wickersham & Taft, “It is not an uncommon cycle to have a strong acquisition market followed by a downturn, particularly as a result of a lot of money fueling M&A activity. Deals in retail need to have continuing steady growth. If the consumer spending model falls off, that can cause problems.”

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