Retail: Left on the shelf

When considering private equity’s involvement in the retail apocalypse, many of the seeds were sewn in the run-up to the global financial crisis, a heyday when retail seemed poised for growth and the idea of Amazon founder Jeff Bezos growing his online retail platform to make him the richest man in the world seemed far off.

Household retail names, many owned by private equity firms, have been casualties in recent years as the industry faces an uncertain future. What once seemed to be a solid bet turned out to be less certain than initially thought, and the secular shift underway now will require the industry to reinvent itself.

“People who bought in [did so] when retail was good cashflow, it was relatively easy to grow each year and add new locations,” says Al Koch, managing director at turnaround specialist AlixPartners, who has helped turn around many major retailers. “That’s a good way to double your money pretty quickly. What was a pretty safe investment isn’t a safe investment anymore.”

The acquisitions of Toys “R” Us by Bain Capital, KKR and Vornado Realty Trust and Sports Authority by Leonard Green & Partners have been two of the highest-profile busts. Perhaps uncoincidentally, both were buyouts done before the GFC, with Toys “R” Us completed in 2005 and Sports Authority in 2006.

“Before the financial crisis, private equity funds were eager to acquire retailers using leverage, in large part because the sector was expected to grow and liquidity was not a concern,” says Gregory Plotko, a partner at law firm Richards Kibbe & Orbe specialising in bankruptcy.

“Credit was more easily available and contained less covenants,” he continues. “After the crisis, we experienced a dramatic tightening of credit along with a systematic change in consumer trends and the growth of online shopping. Liquidity has become a major concern.”

Consumer retail deals done from 2005-2009 have a write-off rate of 11.4 percent, according to data from analytics firm CEPRES Corporation. In other words, private equity firms lost all their money on over one in ten retail deals during that period. The data spans 46 private equity funds buying 70 companies backed by 160 financing rounds. From 2010 to present, the write-off rate based on 79 funds buying 130 retailers is only 1.5 percent.

“Revenue growth was not great on those retail companies bought pre-GFC,” CEPRES Corporation president Christopher Godfrey says. “It took on average seven years to break even on the deals. They have benefitted from recent [valuations]. The IRRs [for the retail deals] in that period was bad due to the longer holding periods and the write-offs, but the multiples overall were decent.”

“There was improved discipline learned by managers,” says Godfrey’s former CEPRES colleague Kevin Cheng, who was an investment solutions manager at the firm. “The other comment I would say is keep in mind the leverage structure over the past 10 years has changed dramatically.”

The Toys “R” Us buyout is an example of how different capital structures today can look. The deal, valued at $6.6 billion in 2005, was financed with only $1.3 billion of equity, according to Toys “R” Us’ 2005 annual report filed with the Securities and Exchange Commission. Gordon Brothers was also an investor on the deal.

Bain, Gordon Brothers, KKR and Vornado could not be reached for comment on the capital structure. Court filings indicate this to be a factor in the toy store’s downfall. “Toys ‘R’ Us, however, has been operating for more than a decade with significant leverage, necessitating the use of substantial amounts of cash each year (approximately $400 million) to service the more than $5 billion of funded indebtedness,” reads a declaration by board chairman and chief executive David Brandon.

Equity’s larger slice

Equity payments have increased in recent years. In 2005, equity cheques in large, broadly syndicated buyouts were just under 30 percent, according to data from Thomson Reuters’ Leveraged Loan Monthly. In the first quarter of 2018, equity contributions were 36 percent.

Other data sets also show the pre-crisis retail deals encountered difficulty, as numbers from The Deal Pipeline, a financial trade publication, showed in an article by two FTI Consulting professionals in the American Bankruptcy Institute Journal. Of the 24 bankruptcy filings by retailers in 2016 and in the first three quarters of 2017, two-thirds were backed by private equity shops. Of those 16, six were done in the 2005-08 timeframe.

Portions of this stem from private equity’s appetite for retail pre-GFC. Almost 40 percent of retail LBOs over the last decade occurred in 2007-08, when the growth prospects of the industry looked a little rosier, according to The Deal Pipeline data.

Guitar Center, a 2007 $2.1 billion LBO also done by Bain, is also in the process of restructuring its debt. The company is currently owned by Ares, which could not be reached for comment. The Los Angeles-based firm acquired Guitar Center in 2014 via a debt-for-equity swap, which extinguished about $500 million in debt, though the firm still has debt left on its balance sheet from the LBO.

In March, Guitar Center proposed an exchange of its $325 million senior unsecured notes due 2020 for PIK notes and warrants that Moody’s says would qualify as a distressed-debt exchange. On 12 April, it announced that $317.96 million had been validly tendered.

“Many of these companies were operating relatively well and expected to grow into their capital structure over time,” says David Silverman, a senior managing director at Fitch Ratings that covers retail.

Fickle customer tastes, the growth of Amazon and niche online retailers and over-expansion have turned out to be real challenges, maybe existential threats, for retailers though. Those factors don’t discriminate by balance sheet or whether a company is backed by a private equity firm.

“We would characterise what is occurring now as a secular change in where shoppers are shopping. We don’t expect to see significant growth soon as someone would expect in a cycle,” Silverman adds.

Private equity firms and their bad bets in retail may be getting all the headlines, but the trends catalysing the dire financial situation for many retailers is secular and the model will need to change.

“I don’t know that private equity backing has that much to do with it other than what’s your leverage,” AlixPartners’ Koch says. He served as the chief financial officer at K-Mart when it reorganised in bankruptcy in 2002, which gave him a view into how retailers deal with a changing competitive landscape.

“It gave me a unique insight into what it was like to compete against Wal-Mart,” Koch says. “In K-Mart’s case, our ‘Amazon’ was really Wal-Mart. Sales dropped by 25 percent, and they never came back. The history of that time was sales would drop and they’d come back.”

We’ve seen portions of this movie before. An April 2008 article ran in The New York Times with the headline, “Retailing Chains Caught in a Wave of Bankruptcies”. At the time, Linens N Things, owned by Apollo Global Management, was on the rocks and later sought court protection, and electronics seller Sharper Image had just filed for bankruptcy.

The GFC claimed many different retail victims, including the department store chain Mervyn’s, which was backed by Sun Capital and Cerberus Capital Management, and bookstore chain Borders, which was a publicly traded company.

“The stock market was cratering, people became paranoid and you were looking at a scary financial position for many Americans,” Koch says. “People stopped buying anything that they didn’t have to buy. We had almost an artificial contraction of demand.”

Defaults on the rise

This time is worse though. Retail sector defaults stood at 8.2 percent in 2017, up from 5.7 percent in 2009. There is little reason to believe that this year will be better. Retailers from Sycamore Partners-backed Nine West Holdings to Apollo-backed Claire’s Stores are among the spate of other companies in the industry seeking court protection that, together, hold billions of dollars in debt.

It’s not as if private equity-backed retailers are alone in taking on debt, a fund manager noted, pointing out that some retailers take on asset-based loans. The sponsor-backed companies are getting an “undue amount of attention”, this person said.

“For certain stronger brands or segments of the retail industry, this will be a point where balance sheets and operations will be restructured, allowing the company to right-size its operations, adapt its footprint and reduce the amount of funded debt they are holding,” Plotko says.

Though it closed hundreds of stores, Gymboree, a $1.8 billion Bain 2010 leveraged buyout, successfully emerged from bankruptcy owned by myriad distressed debt firms, including Apollo, Brigade Capital Management, Marblegate, Nomura Securities, Oppenheimerfunds, Tricadia Capital Management and Searchlight.

Other retailers have emerged from bankruptcy, both those with and without a private equity sponsor. It’s worth noting though, successfully completing a Chapter 11 case does not guarantee a Cinderella story. Multiple retailers have gone through that process a second time, colloquially known as a Chapter 22 filing.

RadioShack, a name once synonymous with American electronics, went through bankruptcy once in 2015 and again in 2017. The first time it exited maintaining a brick-and-mortar footprint, if slimmed down. Hedge fund Standard General acquired more than 1,700 RadioShack stores in the first case and continued operating them.

Then RadioShack succumbed again to financial distress, submitting a Chapter 22 filing in 2017 from which it emerged as an online retailer with a handful of store locations.

However, distressed debt firms are much more adept during this retail downturn, Plotko observes.

“What I find different during this retail cycle are that the players in the distressed debt hedge fund space are more sophisticated and tend to drive the process as opposed to the more traditional [asset-based loan] lenders,” he says.

“There’s a lot more players willing to get into credits at different parts of the capital structure. That has led to the increased use of pre-planning restructuring support agreements and making further investments through the use of rights offerings within a bankruptcy case.”