Private Equity Owners: Not Always Toxic for Retail

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A spate of bankruptcies has plagued the U.S. retail landscape over the past decade. During this time, private equity firms have come under scrutiny due to a slew of bankruptcy filings by private equity-backed retailers: most notably, Toys R Us.

A stimulus-powered surge in consumer spending caused the pace of retail bankruptcy filings to slow dramatically in 2021 and 2022. However, 2023 is set to be a much tougher year as consumers rein in spending and financial markets tighten. That could lead to another round of bankruptcies among retailers owned by private equity.

While leveraged buyouts contributed to some of the retail mega-bankruptcies of the past decade, that era appears to be ending. For better or worse, private equity is likely to play a much smaller role in the retail industry for the foreseeable future.

Clearly, the traditional private equity strategy of piling on lots of debt to finance buyouts can backfire. If a company’s profitability deteriorates, high leverage limits management’s room to maneuver and can lead to bankruptcy when a turnaround might otherwise have been achievable. That said, private equity owners aren’t always bad for retailers, and private equity firms shouldn’t be scapegoated for all of the industry’s woes.

A Track Record of Carnage

In mid-2020, Retail Dive reported that of 104 retailers acquired by private equity firms since 2002, 34 had subsequently filed for bankruptcy.

The biggest private equity buyouts of the past two decades have fared particularly poorly. Looking at the 20 largest private equity deals in the retail sector since 2002, fully half of the companies eventually filed for bankruptcy.

Several of those bankruptcies occurred before the Covid-19 pandemic, led by the 2018 collapse of Toys R Us. The pandemic drove another wave of bankruptcy filings by private equity-owned retailers that had been teetering for years. These included Neiman Marcus, J. Crew, and Belk (all among the top 12 retail private equity buyouts by value).

Most recently, Party City filed for bankruptcy, becoming the first major casualty of the year. While Party City has been publicly traded since 2015, the company remained heavily indebted due to its previous ownership by private equity firms.

To be sure, the past decade has been tough for many retailers. In the pre-pandemic years, the disruptive growth of ecommerce and discounters sparked the so-called “retail apocalypse.” The pandemic and subsequent inflation and supply chain chaos put further strain on the industry. Still, retailers acquired by private equity firms have been especially likely to wind up in bankruptcy court.

Private Equity Doesn’t Buy Healthy Retailers

While there is a clear association between private equity ownership and retail bankruptcies, private equity firms don’t deserve all of the blame for those failures. After all, private equity firms don’t buy best-in-class retailers. Rather, they focus on unloved companies that can be acquired relatively cheaply.

Typically, private equity firms finance around 70 percent of the price of a leveraged buyout with debt and loans, though this can vary from case to case. If a private equity deal is priced at eight times EBITDA (earnings before interest, taxes, depreciation, and amortization) and 70 percent financed by debt at an average rate of 9 percent, interest payments would soak up just over half of EBITDA. That’s already quite burdensome, limiting the company’s flexibility to make capital investments or respond to any setbacks.

For comparison, Lululemon stock currently trades at a valuation of roughly 21 times EBITDA. Ross Stores trades for 18 times EBITDA. Private equity can’t consider buying highly successful retailers like these because the financing costs would be prohibitive.

Instead, private equity deals in retail skew towards weaker brands, turnaround plays, and big-box stores facing tough competition. Even without the extra debt associated with private equity ownership, these businesses are at risk of bankruptcy.

For example, in the department store sector, Belk and Neiman Marcus eventually filed for bankruptcy under private equity ownership. But so did publicly-traded Bon-Ton, Sears, and J.C. Penney, as well as privately-held Barneys New York. Retail is an unforgiving business, and in some cases leveraged buyouts have merely accelerated bankruptcies that were inevitable.

Sometimes Private Equity Succeeds

While private equity owners have hastened the demise or bankruptcy restructuring of numerous retailers, in some cases they have implemented positive changes.

Notably, the largest retail private equity deal in history has been a huge success. BC Partners bought PetSmart for $8.7 billion in 2015. PetSmart subsequently acquired online pet retailer Chewy for $3.35 billion in 2017. The move proved extremely far-sighted. Thanks to a combination of strong customer loyalty, ecommerce growth, and a surge in pet-related spending during the pandemic, Chewy now has a market value of around $20 billion. By selling part of Chewy in a 2019 IPO and spinning off the rest of its stake in 2021, BC Partners has pared down PetSmart’s debt while earning a huge windfall for itself.

Elliott Management’s acquisition of Barnes & Noble has become the most dramatic private equity-led turnaround in recent retail history. The struggling bookseller agreed to a $683 million leveraged buyout in June 2019. At the time, B&N had been struggling with sagging sales and earnings for years. Revenue fell from $4.16 billion in fiscal 2016 to $3.89 billion in fiscal 2017 and $3.66 billion in fiscal 2018 and declined further in fiscal 2019. Meanwhile, adjusted EBITDA slipped from $187 million in fiscal 2017 to $145 million in fiscal 2018. A projected rebound in fiscal 2019 never materialized.

Considering this gloomy trajectory, the pandemic could easily have killed B&N. But Elliott Management wisely installed James Daunt as CEO on top of his existing duties as CEO of British bookseller Waterstones (also owned by the fund). Daunt cut corporate overhead, redesigned store layouts, and gave store managers more autonomy to curate title selections based on local tastes.

The results have been spectacular. B&N has returned to top-line growth, margins exceed pre-pandemic levels, and the chain has started to expand its store footprint again. B&N is even moving into some spaces previously occupied by the now-defunct Amazon Books chain.

It has been obvious for at least a decade that B&N needed to change radically from the strategies that made it a powerhouse during the 1990s. But despite numerous CEO changes, B&N failed to do so as a public company. Without the takeover by Elliott Management, the pandemic may well have driven B&N out of business. More broadly, the threat of private equity involvement can act as a counterweight to board and management complacency at struggling retailers.

A Moot Question?

To some extent, the debate about how private equity dealmaking impacts retailers is becoming less relevant. Private equity firms generally don’t make money when their portfolio companies go bankrupt. Not surprisingly, private equity firms’ interest in the retail sector has tailed off as the bankruptcy tally has risen. In recent years, retail-sector leveraged buyouts have typically been smaller deals, such as the 2019 B&N takeover. (Multibillion dollar deals in early 2021 for pandemic darlings At Home and Michaels were notable exceptions.)

A surge in interest rates over the past year has caused a broad slowdown in private equity deal activity. Rising rates make it very hard to finance leveraged buyouts, particularly in the retail industry, where lenders were already demanding sky-high interest rates to compensate them for bankruptcy risk.

In short, while leveraged buyouts contributed to some of the retail mega-bankruptcies of the past decade, that era appears to be ending. For better or worse, private equity is likely to play a much smaller role in the retail industry for the foreseeable future.

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