Queues to back retailers are getting shorter

When Toys R Us filed for bankruptcy protection in the US and Canada this week, there were some familiar firms backing the Wayne, New Jersey-based retailer’s bankruptcy financing, including Angelo, Gordon, HPS Investment Partners and Redwood Capital Management.

In other retail bankruptcies this year, GSO Capital Partners and KKR were lenders on the Payless Shoes and RadioShack debtor-in-possession facilities, respectively. The above are all marquee names in the distressed and special situations-investing universe; shops that step in to pour money into companies when others are running for the exit.

For more mainstream investors, opportunities in retail remain if you can find businesses that check all the requisite boxes. But conversations with market sources lead to the conclusion that private debt fund managers, save for their distressed debt desks, aren’t exactly itching to put money into retail, which could be a problem for the sector’s prospects.

Quality retailers, with a loyal customer base and a strong online and in-store presence, may suffer along with the stragglers if alternative lenders shy away because of the perceived toxicity of the sector as a whole.

Keys to identifying a good company include examining relationships with the retailer’s vendors as well as its debt maturity schedule and the company’s competitors, says Moody’s retail analyst Charlie O’Shea. Good relationships with vendors, which could result in more favourable contract terms and staggered maturities for the company’s liabilities, allow for more financial flexibility and better liquidity.

Retailers sometimes wrongly identify the nature of the competition, adds O’Shea, and may struggle to answer the most basic question: does your business have a reason to exist?

Perhaps counterintuitively, bricks-and-mortar is still an integral part of the retail business. Census Bureau data show ecommerce counted for only 8.9 percent of all US retail sales in the second quarter. If car and gas sales are taken out, that number increases to around a projected 18 percent for the year, says Fitch senior retail analyst Monica Aggarwal.

This still means that over four-fifths of sales are based on bricks-and-mortar. A PricewaterhouseCoopers survey on retail trends this year showed 41 percent of global consumers shop in a store at least once a week. A good online presence is important, though, because most sales growth is occurring on the internet, Aggarwal adds.

Faced with increasingly strong online competition, Toys R Us is the latest in a line of private equity-backed companies (taken private in 2005 by by Bain Capital, KKR and Vornado Realty Trust) to file for bankruptcy. Gymboree (also a Bain portfolio company) and Payless Shoes (backed by Golden Gate Capital and Blum Capital Partners) also fall into that category.

“The common thread [among some distressed retailers] is financial sponsor involvement, because that brings in the leverage,” O’Shea says. “[The LBO structure] can be a less than optimal fit in the wrong company in the wrong sector.”

Markets are bearish on the sector’s distressed names – the median price on broadly syndicated term loans in the sector 30 days after a default is 40 cents on the dollar, the lowest among all sectors, according to Fitch Ratings leveraged finance analyst Eric Rosenthal. The equivalent number for the energy sector is 80 cents on the dollar.

Highly levered capital structures, the growth of online shopping and changing customer tastes have sent numerous household names into Chapter 11. Perhaps understandably, alternative lenders are sceptical about lending into the sector in the face of these challenges. But that may create the kind of funding gap they typically claim to be good at closing.

PS: PEI is currently conducting its annual institutional investor research study, which seeks to understand how LPs approach the alternative asset classes. We would like to know where you, as an investment professional, see opportunities in the coming 12 months, how you have invested in the past 12 months and how macroeconomic factors may affect your decisions.

We are asking for 10 minutes of your time to complete the questions found HERE.

In return for your participation, you’ll receive a complimentary copy of the final research report and we will also donate $5 to UNICEF for each completed response.

The deadline for your submission is Friday, 13 October, 2017.

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