Neiman Marcus Inc., J. Crew Group, Sears Holdings Corp., The Limited, Rue 21…What do they all have in common? Private equity owners and the ills they bring.
Face it, big money doesn’t guarantee big success. While some of retail’s woes come down to simply bad luck, bad timing or shaky strategy, the root problem at many of the most troubled retailers today is the same: bad debt. And most of that came with private equity players that made the sellers — and sometime management — rich, but more often left the retailer hobbled and unable to adapt to the new environment.
Big dreams up and down the mall have been wrecked by a tidal wave of change. Shifting shopping patterns, the growth of e-commerce and the rising Millennial preference to spend on experience over possessions are all pushing retailers hard to reinvent and right now.
But many companies that appeared to “win” in a gentler time for fashion retail — and nabbed the headline-grabbing private equity buyout along the way — now find themselves pushing ahead into an unusually uncertain future while dragging along billions of dollars in debt that is growing more unmanageable.
For some, it’s been just too much.
The Limited, debt-laden and owned by Sun Capital Partners, liquidated in January. Versa Capital-owned Wet Seal Inc. also liquidated, and Eastern Outfitters, the parent company of Bob’s Stores and Eastern Mountain Sports, filed for Chapter 11 bankruptcy. Rue 21 is struggling under the ownership of Apax Partners and closing hundreds of stores, and Gymboree, taken private by Bain Capital in 2010 in a deal estimated at $1.8 billion, is a potential bankruptcy.
Others are struggling mightily and looking for a path forward.
Neiman Marcus — which passed from TPG and Warburg Pincus to Ares and the Canada Pension Plan Investment Board in a $6 billion deal in 2013 — is now laden with $4.6 billion in debt.
That’s too heavy a load given Neiman’s current business. The company has been testing the waters and looking for a buyer for some time while officially abandoning its proposed initial public offering in January.
Richard Baker’s Hudson’s Bay Co. is in talks to buy the retailer, but a deal still seems to be a ways off and has been complicated by potential legal issues tied to Neiman’s move to cordon off its Mytheresa.com operations and three Neiman’s stores away from lenders and into “unrestricted subsidiaries.”
“HBC is having a hard time getting a deal finished,” said one source close to the situation. “The owners have been stripping assets out of Neiman’s and they did it at the last minute. There are a lot of unhappy bondholders.”
While there has been some speculation of a second bidder besides HBC, no names have surfaced.
Private equity firms have been attracted by Neiman’s luxe customer base, which have the ability to spend in good times and bad, making for more reliable collateral for credit.
Don’t feel too sorry for the private equity firms: Most of them no doubt have made at least some profit on their initial investment no matter how disastrous it ultimately turned out to be.
Retail has always been a cash-rich business and the money that flows through stores made them tempting targets for debt-savvy acquirers putting together billion-dollar (or multibillion-dollar) deals. That’s because buyers could get away with throwing in just a little bit of their own equity while they “lever” up the company, rolling the rest of the purchase price into loans that are ultimately the responsibility of the retailer.
It’s an approach that can work, when it’s applied responsibly and growth is abundant.
But, ah, those were the good old days. When times are tough and growth is slow — like retail now — loading the companies up with debt can be a recipe for disaster. And while this is an age of retail when there’s plenty of blame to go around — between stores that were too slow to adapt to the Internet evolution and brands that were too ready to simply serve up what worked last season — it’s become popular to point a finger at big investors.
“We do think private equity has been more of a detriment,” said David Simon, chairman and chief executive officer of Simon Property Group, venting on a conference call with Wall Street analysts. “And by the way, most of these guys are my buddies, OK? But I mean, when you lever up any business, whether it’s the mall business, the retail business, and you can’t invest in your product, you’ve got a problem. We’ve seen a lot of that….I’m going to get a lot of criticism from all my buddies, but that’s the truth. So if you look at kind of where that pressure point has been, it’s more than just the apparel business is bad. It’s because, well, they couldn’t survive with leverage on it. They pay the special dividend, they bought stock back. They did some financial maneuvering that increased the pressure that wouldn’t allow them to deal with a kind of non-robust middling environment.”
Instead of building retailers up, private equity firms in many instances have pulled them apart, sold off assets and closed down operations for the benefit of their funds and at the expense of employees and the integrity of the brand itself.
It’s a shrewd formula for profits: minimal equity, low-interest loans that don’t come due for years, expectations of solid EBITDA, and cost-cutting. Generally, the goal is for the funds to realize a profit on their investment of 20 to 25 percent returns.
Mark Cohen, director of retail studies, adjunct professor of marketing at Columbia Business School and a former Sears Canada ceo, said: “The m.o. has always been, ‘We save sick companies from their missteps, we unlock shareholder value and provide tremendous opportunities for companies to be reborn.’ Except when business is bad, the inevitable debt burden often becomes problematic if not downright impossible to manage.”
Typically the plan is for the retailer to not pay off the debt, but to service it and go public and roll it over, or sell the company to another private equity firm.
“It’s like having a mortgage that you never pay off,” Cohen said. “You can refinance, if your performance is good enough to find a lender, but at some point it comes due.”
According to an analysis by AlixPartners, more than half of the retailers that have gone bankrupt this year were backed by private equity firms, up from just under a third for the previous five years.
“The private equity model is one that leaves companies having trouble with very few options,” said consultant Jonathan Low, partner at Predictiv.
Low noted that changes to bankruptcy laws in 2005 made it harder for companies to restructure in court and come out as going concerns (that actually keep going).
Take that and add in sweeping changes in technology and the Amazon juggernaut and Low said “the private equity attitude is that, ‘We’re not going to hang around and see if things get better, we’re just going to pull the plug and move on.’”
And while people can point fingers all they want when things go wrong, leveraged buyouts are often structured in a way that leave no question as to who’s holding the bag.
“I think it’s pretty ruthless,” said Low, noting many private equity dealmakers like to use the phrase: “If we get cut, you bleed.”
That attitude does not characterize everyone in the field, though.
And while retail has proven problematic for private equity players, there have been some successful buyouts among branded apparel businesses and budding retailers — where investors take a stake, provide a capital boost to supercharge growth and flip the company, making everyone richer in the process.
The latest example comes from Bain, which invested in Canada Goose in 2013 and took the company public this year, leaving it with a market capitalization of $2 billion.
Other private equity wins include: The 2012 acquisition of David’s Bridal by Clayton, Dubilier & Rice, which boosted margins with a business model switch; Cole Haan’s global expansion since it was bought by Apax in 2013; Quiksilver, renamed Board Riders Inc., was bought last year by Oak Tree Capital, which cut costs, reengineered the sourcing, streamlined the inventory and knocked off 15 weeks in the product development cycle.
Jack L. Hendler, ceo of advisory and investment banking firm Avalon Net Worth, said: “Private equity investors that are knowledgeable in the consumer retail sector have for the most part done well with their acquisitions, as long as they implemented cost savings, restructured the sourcing, warehousing and distribution to be more efficient, and tackled inventory control and crucially strategic back-room administrative savings, like utilizing one cfo, not six; or one large distribution center, not 12.”
And while the formula almost without exception includes debt, each private equity company has its own style, with some becoming very involved in the businesses they buy and others keeping operations at arm’s length.
“Even when I was an investor, I ran a lot of companies from my office in Boston,” said James Rhee, who controls Ashley Stewart and is both a private equity investor and an operator. “I am a lot more hands-on than most private equity investors.”
At J. Crew, the private equity owners TPG Capital and Leonard Green & Partners give chairman and ceo Millard “Mickey” Drexler freedom to run the business, which he has a major stake in. But J. Crew is carrying $1.5 billion in debt after the partners took it private a second time, which is increasing pressure on the retailer to figure out a turnaround formula.
While it works away, the retailer’s private equity sponsors continue to get paid. According to the company’s latest annual report, the investors get “an aggregate annual monitoring fee prepaid quarterly equal to the greater of 40 basis points of consolidated annual revenues or $8 million.” The sponsors also receive reimbursement for out-of-pocket expenses tied to its services. J. Crew recorded an expense of $10 million last year “for monitoring fees and out-of-pocket expenses.”
But the biggest misstep of them all — at least for now — was when Pershing Square Capital Management’s William Ackman acquired a $900 million stake in J.C. Penney Co. Inc. in 2010, gaining influence and a seat on the board. He pushed the board to get rid of longtime ceo Myron “Mike” Ullman 3rd and to hire former Apple executive Ron Johnson as ceo, whose reinvention scheme practically buried the company.
Ackman told his own investors in 2013, as the Penney’s play was unraveling, that of his firm’s 19 “long” investments, there were only three “failures” — Borders Group, Target and J.C. Penney.
“Clearly, retail has not been our strong suit, and this is duly noted,” he said.
While Ackman has continued to agitate for change with his investing strategy, making bold bets and rattling boardrooms, he has stayed away from retail.
Others have kept at it and lately, the private equity flops seem to outnumber the wins.
If the private equity model seems ill-at-ease in retail, that’s because it’s an approach experts said was successfully employed to remake industrial companies, which have lots of valuable physical assets, such as machinery or factories, and was then only later used for retailers as investors sought new targets.
“In traditional PE, you go in, use the assets to provide some leverage, you cut some costs, you turn it around,” said Greg Portell, lead partner in A.T. Kearney’s consumer products and retail practice in the Americas. “In a retail environment, there’s not a whole lot of assets that are material, at least once you’ve taken care of the real estate part of it. In an ideal world, PE would provide the capital that cash-strapped retailers need to reinvent themselves, and instead they’re in many cases not taking that long-term view.
“Private equity definitely has its own score card,” Portell said. “Lever it up with debt, you collect some fees and the retail operation becomes secondary to the investment thesis.”
But while one would think the retail landscape littered with failed or struggling firms would serve as a cautionary tail for private equity players, that doesn’t seem to be the case. There is too much money sloshing through the investment system for private equity players to ignore the sector, so the dance is bound to go on.
“There are too many high-profile, distressed properties in the U.S. market today; that is tempting hunting ground for any speculative investor,” Portell said. “You’re going to see both the traditional PE firms coming after U.S. retailers and you’ll see some more adventurous global investors moving into the market to try to get a foothold.”
Let’s hope they figure out a profitable formula along the way.
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