The Private Equity Firms at the Core of Brick & Mortar Retail Bankruptcies

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by Wolf Richter, Wolf Street:

An astounding list of the meltdown: PE firms doomed the retailers.

One of the big forces in the brick-and-mortar retail meltdown are private equity firms that acquired retail chains via leveraged buyouts during the LBO boom before the Financial Crisis or more recently. Numerous of those retail chains have now filed for bankruptcy.

A PE firm typically borrows to undertake the leveraged buyout. But instead of carrying the debt at the firm, the debt is loaded on the acquired company, on top of the debt it had before the buyout, and it has to service that large pile of debt.

In addition, PE firms typically extract fees and “special dividends” from their portfolio companies which will fund them with additional debt. These fees and special dividends are tools with which PE firms extract profits up front. Lenders and other creditors carry the risks.

The final goal is to unload the portfolio company by selling it either to a large corporation or to the public via an IPO within a few years (seven years is a rule of thumb).

This works ok-ish in a booming industry. But brick-and-mortar retail – particularly apparel stores, shoe stores, sporting goods stores, department stores, and the like – came under withering attack from online sales in recent years. This environment causes PE-firm owned retailers to suffocate under their debts.

Toys ‘R’ Us shows how this was done: PE firms KKR, Vornado Realty Trust, and Bain Capital Partners acquired the publicly traded shares of Toys ‘R’ Us in an LBO in 2005. In 2004, Toys R Us had $2.2 billion in cash and short-term investments. By Q1 2017, this had collapsed to just $301 million. Over the same period, long-term debt surged from $2.3 billion to $5.2 billion.

In other words, “cash minus debt” was -$112 million in 2004. By 2017, it had ballooned to -$4.9 billion.

While the PE firms were busy extracting cash, the company, cash-strapped and focused on cost-cutting, failed to create an online presence that could compete with Amazon and others, didn’t successfully make the transition to electronic devices, video games, and apps, and let its physical stores deteriorate. It should have spent the last decade investing heavily in its future. Instead, it was forced to borrow large amounts of money just to enrich its PE-firm owners. In September last year, it filed for Chapter 11 bankruptcy.

Other retailers that had been acquired by PE firms were similarly waylaid. When Amazon and others barged into their territory, they had no means to invest and fight back. They were sitting ducks, among the first to succumb in the brick-and-mortar retail meltdown.

The PE firm’s goal of exiting these companies got very difficult when it became apparent what was happening in brick-and-mortar retail. But some PE firms were still able to unload their portfolio companies before the “IPO window” closed on them, and investors paid the price.

Container Store is an example. It was acquired by PE firm Leonard Green in July 2007. In November 2013, when the “IPO window” was still wide open, Leonard Green began unloading the company at an IPO price of $18 per share. Two months later, shares peaked at $47.07. The hero of Wall Street. Then reality began to bite. On Friday, shares closed at $5.01, down nearly 90% from the peak.

Other PE-firm-owned retailers, after making it out the IPO window, collapsed under their debts and filed for bankruptcy. An example is Fairway Group Holdings, parent of iconic New York food retailer Fairway Market. It was acquired by PE firm Sterling Investment Partners in 2007 and unloaded via an IPO in April 2013. In May 2016, it filed Chapter 11 bankruptcy.

These kinds of IPOs taught investors valuable lessons about brick-and-mortar retailers that PE firms are trying to unload. And since then, numerous PE-firm owners had to scuttle their plans to exit and are now stuck with their LBO queens.

A brilliant example is Neiman Marcus, which is struggling with $5 billion in debt. Their owners Ares Management and the Canada Pension Plan Investment Board filed for an IPO in October 2015, but at the last minute postponed. In December 2015, the luxury retailer reported its first sales drop since 2009 – and a lot of red ink. And hopes of an IPO went up in smoke.

Then there’s Albertsons Companies, the product of several LBOs by PE firm Cerberus Capital, real-estate investors Klaff Realty and Lubert-Adler, REIT Kimco Realty, and shopping center owner Schottenstein Stores. They acquired Albertson’s in 2005, Safeway in 2015, and some other supermarket chains along the way.

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