Testing times for retail LBOs

A slump in consumer spending could test the staying power of private equity owners of retail companies in Europe. By Robert Venes.

Last week, credit ratings agency Fitch Ratings published a report, “European retail LBOs facing increasing pressure”, warning that a poor trading environment in Europe could impact negatively on highly-leveraged retailers.

Given that the report was published on the same day that Debenhams, one of the best-known recent retail LBOs in the UK, reported that it had doubled profits and exceeded £2 billion (€2.97 billion; $3.46 billion) in sales in the year to September 3, that warning had less impact.

In fact, a column in Monday’s Financial Times referred to the report’s “seemingly unfortunate timing”. However, as well as pointing out that the media frequently highlight the attention-grabbing success stories over the lesser-known under-performers, the FT did acknowledge that timing was a fundamental part of Fitch’s analysis – the dangers for buyout firms and their retail portfolio companies may seem distant now, but could sib appear a lot more real a little further down the line.

Talking to PEO, Pablo Mazzini, an associate director at Fitch’s leverage finance team in London, says that the issue is not just about Debenhams, or indeed the current trading environment: “Not all retail LBOs are doing badly, and Debenhams is probably a good example of one that is doing well, but given the highly leveraged structure of most of these companies, they may encounter difficulties in the next 12 to 18 months, especially in the UK, should trading remain tough or even get worse.”

Retail, says Mazzini, is a high fixed cost industry, where the level of head room to improve profitability is limited in times of a prolonged downturn or pricing pressure. For instance, retailers have to pay long-term leases and rates related to their stores as well as salaries and pension costs. As a result, a small swing in sales can seriously impact the bottom line.

In addition, Mazzini suggests that gross margins could be impacted by the likely return to strength of the US dollar. “Financial sponsors have encouraged the sourcing of products abroad as it is much cheaper, and they have been successful as the US dollar was weak,” he says, noting that the dollar is generally used to pay for products sourced from Asia.

However, the main concern, says Fitch, is not how European buyout firms will respond when under pressure. Rather, it is how they will behave when they are already in the comfort zone but their portfolio companies despite facing tough conditions – that is to say, after a buyout firm has completed a refinancing and recovered its investment through a dividend repayment, as in the cases of Debenhams, New Look or Vivarte in France.

With less of a financial incentive to turn around the situation, Mazzini asks whether private equity firms will have the mettle to plough further resources and cash into a struggling business in a subdued trading environment.

“There are no liquidity issues currently for any retail LBOs, although some of them are more exposed to the current trough in sales,” says Mazzini. “However, when and if [a liquidity problem] arises, will private equity firms be able or willing to support these businesses, or walk away and leave [them] with no support if they have realised their investment through a dividend repayment?”

The answer will, in part, depend on how far away from its target return the private equity house will be post-dividend. Reputational issues will also play a role: letting a household name retailer slip into bankruptcy without staging a serious rescue operation first may well damage a sponsor’s standing in the market place.

For the time being, the prospect of a retail LBO meltdown remains hypothetical, but it is one that buyout firms, especially those that have cashed out through a refinancing, will have to consider if consumer sentiment should worsen going forward.