Private equity had a banner year in 2017. So why did so many PE-backed retail businesses file for Chapter 11?
here’s a mystery at the heart of the recent wave of retail bankruptcies.
By most accounts, 2017 was a banner year for private equity (PE). The number of leveraged-buyout (LBO) deals and lending to sponsor-owned companies were at their highest levels in a decade. Investor inflows into new buyout funds were strong.
Yet not everything was rosy in the PE investment world last year. Between 2016 and late-2017, PE-owned companies accounted for 35 percent of all large Chapter 11 bankruptcies, notably higher than in preceding years. Among retailers that number was almost twice as high, with 67 percent (16 of 24) of Chapter 11 filings by retailers in 2016-2017 being PE-backed companies.1
At a time when PE investments are doing relatively well elsewhere, we’re left to wonder what’s going on within retail that is causing such a disproportionate share of PE-owned failures? (For that matter, why has there been so little coverage of the phenomenon by the business media?)
Clearly it’s the wrong time to be a leveraged retailer. Here’s how the sector arrived at this precarious position, and why troubled retailers should proceed with caution.
1. Retail Is Just Not Suited to Leveraged Buyouts
Retail can be a tricky business, with its mercurial product and style cycles, fickle customers and low profit margins. It’s also more precarious because of today’s ultra-competitive and complex business environment. Additionally, more and more of commerce is happening online —online retail sales have tripled since 2008 — contributing to the industry’s performance slump.
Publicly-owned retail chains, on average, carry funded debt at about two times earnings before interest, tax, depreciation and amortization (EBITDA). That is considerably lower than the leverage employed in other industries. Historically, retail businesses have modest amounts of funded debt, which is one factor that made them appealing as potential buyout targets.
As a low-growth, low-margin industry, the retail sector should seem unattractive to buyers. And yet, interest in rummaging through retail targets has persisted for decades. Deals may look good on paper; but often they are not as successful in execution, judging by some renowned flops of large LBO failures over the years, like Federated Department Stores, Sports Authority, Revco Drug Stores and, more recently, Gymboree and Toys “R” Us.
Highly levered businesses have less free cash flow available for reinvestment and this constraint can negatively impact their competiveness. Toys “R” Us may be one example. Retail watchers have suggested that a contributing factor to its failure was persistent underinvestment in its online business since going private in 2005.
2. Timing of Deal is Everything
In the last decade, almost 40 percent of retail LBOs happened amid a huge wave of LBO transactions between 2007 and 2008 — right before the financial crisis. These deals occurred at the height of market valuations, were expensive and executed with excessive leverage. (Sponsors paid an average of 10 times of EBITDA for retail buyouts.) In addition to overpaying for transactions, the retail market was also on the edge of a rapid change, with the migration of sales from brick and mortar stores to online sites.
The poor timing of these kinds of buyouts did not cease when the financial crisis ended. When credit markets began to thaw in 2011, sponsors again took advantage of perceived bargains caused by retail’s instability, with 33 percent of LBOs occurring between 2011 and 2013. True, prices were more reasonable than they were in 2008, but sponsors underestimated the disruptive impact that online shopping would have on the retail landscape, while discretionary consumer spending remained tepid. Despite the lower leverage on post-recession transactions, these deals did not fare much better than the previous wave; in fact, we’re likely to see a notable number of reorganizations of businesses bought during this time in the next couple of years.
3. Private Equity and Retail Have an Uncertain Future Together
Scared off by declining operating performance throughout the retail sector since 2014, sponsors have avoided PE deals as of late, with only 14 percent of retail LBOs occurring between 2015 and 2017. It seems unlikely that capital markets and lenders will support retail buyouts like they did in the past until retail sees sustainable improvement in operating metrics and finds stability from the disruption of online retail.
Of course, there are exceptions to the malaise affecting the sector. Niche store-based chains with faithful customers, such as Lululemon and Five Below, are thriving and continue to expand. The reverse retail model also seems to be working: some online-only players are successfully expanding into the world of brick and mortar, like Warby Parker.
But compelling growth stories in store-based retailing are rarities these days. Bottom-fishing deals, where sponsors take control of reorganizing retailers or buy into highly distressed situations, are getting closer attention and have the potential to be profitable. In most cases, however, sponsors aren’t biting, despite recession-like valuations since 2016.
Alternative Plans: Act Quickly
Retail is proving to be a challenge for private-equity sponsored businesses, but there are chains that filed Chapter 11 and have emerged. The key is to reorganize quickly with prenegotiated plans and creditors’ support. Payless ShoeSource, True Religion and rue21, are three examples, each taking about four months from filing to emergence.
Failed retailed buyouts need to take quick action on an alternative plan: Negotiate a consensual plan with creditors before filing, significantly reduce leverage via the equitiaztion of debt and close underperforming stores and renegotiate leases wherever possible. Of course that's easier said than done given the short timelines often imposed on a retailer once it has filed for bankruptcy. Finally, high leverage can be restructured in the bankruptcy process but competitive and operational challenges take considerably longer to rectify, if ever.
What the Future Holds
As for future deals, sponsors should proceed with caution in the retail space despite still modest market valuations for many public chains. Retail is not generally an asset-rich business that can support high debt. Stores are typically leased, inventory is often financed with secured lines of credit and intellectual property values can dissipate as a chain becomes distressed.
Moreover, given the unpredictability of the industry, who can say where retail will be five years down the road? Many struggling retailers will likely confront impatient vendors and lenders, and will face the prospect of liquidation once in bankruptcy, so we will expect more bottom feeder deals.
By the end of this year, we'll almost certainly see fewer retail buyouts than we can ever recall. With constantly changing customer needs and expectations, plus continued digital disruption, heavily indebted companies will have trouble keeping up with better funded competitors like Walmart and Amazon. Even recently reorganized businesses are not safe from disruption and remain vulnerable. It's no wonder retail has seen more than its fair share of "Chapter 22" filers.
But that's a mystery for another day.
1. All data contained herein sourced from The Deal Pipeline.