Private Equity’s Impact on Retail, Why People are Concerned

Picture of a Toys “R” Us store
 

By Tricia McKinnon

The pandemic in many ways has awakened us to many things we did not see before. Or if we did see them, we weren’t paying enough attention. Within the retail sector one of those things is private equity. Private equity firms like KKR and Bain Capital are behind the buyouts of some of the most well-known names in the retail sector. From Toys “R”’ Us to Payless ShoeSource to Neiman Marcus private equity has made its mark. 

Private equity firms typically use large sums of money to buy a retailer, take it private, turnaround the business only to sell it later at a profit. That’s what happens if all goes well. In some cases as is the case with Dollarama and Canada Goose private equity ownership has resulted in positive outcomes. But in many cases like Neiman Marcus or J.Crew the outcome is less than desirable. If you are curious about private equity and how it has impacted retailers and the sector at large consider these four main areas of concern.

1. Dilution of assets 

Retail is often a good private equity candidate because of the stable cash flows retailers generate and their lucrative real estate portfolios. In the past decade private equity companies and hedge funds have made controlling interest investments in more than 80 major retailers. “Retail used to be kind of a golden goose for private equity firms, because in order for an LBO (leveraged buyout)  to work, the company has to be fairly mature with fairly regular cash flows,” says Elisabeth de Fontenay, a Duke University School of Law Professor specializing in Corporate Finance. “Under normal conditions, that’s kind of the definition of retail.”  It “works out just fine as long as the economy and sector you’re invested in continues to grow.” “If the sector is shrinking, it has been bad news.”

In many private equity transactions the new ownership sells off real estate assets to generate cash flow. Then the retailer is forced to lease back its own stores. Often the money from the sale of assets is used to pay the private equity owners dividends and management fees. This is one of the main criticisms of leveraged buyouts and private equity firms, the owners make money while the retailers are often left in distress. Take Fairway. Fairway is a New York based grocery chain. Private equity firm Sterling Investment Partners made a $150 million investment in Fairway in 2007, mostly consisting of debt for an 80% state in the company. Fairway was on the hook for that debt which landed on its balance sheet. 

A little over five years after that initial investment by Sterling, Fairway issued an IPO in 2013. Fairway’s IPO filing stipulated that an $80 million dividend would be paid to Sterling, its private equity owner. If that was not enough another $17 million in fees was paid to Sterling and its management team. By 2015 Fairway’s CFO admitted that its debt levels were constraining the company’s ability to achieve any of its long term plans. In 2016 Fairway filed for bankruptcy and again at the beginning of 2020. “This is another insidious example of private equity killing a business,” said Mark Cohen, Director of Retail Studies at Columbia Business School. “These guys caused them to open stores that maybe were completely ill-advised.”

Similarly J.Crew paid in excess of $760 million in dividends and fees to its ownership team since it was bought out in 2011. These are not small sums of cash especially for retailers facing stiff competition in a sector often characterized by thin margins. Staying  competitive as eCommerce penetration continues to rise also requires a hefty investment. For example, Walmart in an attempt to close the gap between itself and Amazon, bought once popular Jet.com for $3.3 billion, a business which Walmart has since retired. Walmart’s eCommerce business lost $2 billion in 2019 indicating how tough it is to maintain profitability in this area. In addition to spending on eCommerce infrastructure retailers also have to make ongoing investments in stores and staffing. 

“One of the defenses of private equity right now is, they’re saying these are structurally declining businesses already, and, look, that is a part of it,” says Andrew Park, a Senior Policy Analyst at Americans for Financial Reform. “But again, having to service that debt makes these businesses hard, and when you see these companies blatantly taking money away, that’s the element that has really led to criticism.”

2. Employees that pay the price

Another key lever private equity firms use to extract value is to reduce headcount. In a report from the Center for Popular Democracy entitled “Private Equity, How Wall Street is Pillaging American Retail” it says: “in the last 10 years, a staggering 597,000 people working at retail companies owned by private equity firms and hedge funds have lost their jobs. An estimated additional 728,000 indirect jobs have been lost at suppliers and local businesses, meaning Wall Street’s gamble on retail has led to more than 1.3 million job losses in total.”

The job losses often start with productivity efforts where employees are laid off in an effort to create a more efficient business. It’s those very employees that are the lifeblood of retail organizations. It’s those employees that are either frontline staff serving customers or are in the buying organization that are needed to keep a retailer going. 

Critics also argue these cuts are used to finance fees and dividends paid to management and directors, many of whom come from the private equity firms themselves. Take Toys “R” Us. It was bought in 2005 by KKR, Bain Capital and Vornado Realty Trust in a $6.6 billion buyout that used $5 billion in debt. Following the purchase staff positions were eliminated increasing the burden on remaining employees. Toys “R” Us also struggled to effectively compete with Amazon since toys is a category that is heavily purchased online. Paying $400 million in interest to service its debt obligations also did not help.

Toys “R” Us eventually filed for bankruptcy in 2017. A lawsuit from creditors that lost hundreds of millions of dollars once Toys “R” Us liquidated alleges that between 2014 and 2017 $18 million in fees were paid to Bain Capital, KKR and Vornado Realty Trust as well as Dave Brandon, Toys “R” Us’ former CEO.

31,000 people ultimately lost their jobs as Toys “R” Us liquidated. Speaking to lawmakers in a 2019 hearing called “America for Sale? An Examination of the Practices of Private Funds” Giovanna De La Rosa, a 20-year Toys “R” Us veteran said: “Toys “R” Us had a decades-long severance policy — a week of pay for every year of service to the company. But when our company liquidated, the employees were left with nothing." "My coworkers and I were left with nothing while the executives and private equity owners walked away with millions." 

Facing pressure, towards the end of 2018 KKR and Bain established a $20 million fund to pay for severance, although it was still short of the $75 million in severance owed.

3. Onerous debt levels

Perhaps the biggest issue with private equity is the enormous debt burden it places not on the private equity firm but on the retailer itself. To facilitate a buyout private equity firms raise debt, billions of it at times. That debt then falls on the balance sheet not of the private equity firm but on the balance sheet of the retailer. The retailer is then liable to pay the debt back. 

Private equity firms typically only put up a fraction of the sale price using their own funds. It is estimated that general partners from the private equity firm involved in a transaction only contribute 1% to 2% of the equity required to finance the deal. Sounds like a lucrative play for the private equity firm, substantial upside with limited downside. 

That debt results in large interest payments. Money that could be deployed for better uses such as investments in eCommerce technology or in store labour. Before entering bankruptcy proceedings, private equity backed J. Crew and Neiman Marcus had debt levels of $1.7 billion and nearly $5 billion respectively. Both retailers have paid hundreds of millions in interest costs to service that debt. Toys “R” Us was paying $400 million annually to service its debt before it went bankrupt. “A lot of brands are hanging on by a thread, and Neiman was one of them,” said Milton Pedraza, Chief Executive of the Luxury Institute, a retail consultancy in New York. “It had so much debt — from being bought and sold, and bought and sold — that really hampered its ability to invest and innovate.”

Writing about private equity in a post last July on Medium entitled “My Plan to Reinvent Wall Street” Massachusetts Senator Elizabeth Warren wrote: “consider ShopKo, a discount retailer founded in 1961. By the end of 2005, it had more than 350 stores. Then, the private equity firm Sun Capital took over, loading Shopko up with more than a billion dollars of debt. Sun Capital soon forced Shopko to sell one of its most valuable assets — its real estate — requiring the company to lease back its own stores. Sun Capital made ShopKo pay it a $50 million dividend and quarterly consulting fees of $1 million. It made Shopko pay an additional 1% consulting fee on certain transactions — which meant the company had to pay Sun Capital an extra $500,000 fee for the honor of paying it that $50 million dividend.

When the company finally crumbled and filed for bankruptcy, hundreds of workers lost their jobs and didn’t even receive the severance pay they had earned through their work. But Sun Capital walked away with a juicy profit.” 

Do you like this content? If you do subscribe to our retail trends newsletter to get the latest retail insights & trends delivered to your inbox

4. Bankruptcy

Bankruptcies are a severe consequence of these transactions with private equity owned businesses twice as likely to go bankrupt as public companies. Between 2012 and 2019 ten of the 14 largest retail chain bankruptcies were from retailers backed by private equity. In 2016 and 2017 66% of retail companies that filled for bankruptcy were backed by private equity. Private equity owners often prove to be more adept at generating substantial returns for themselves than turning around the retailers they own. 

This is a list of just a few private equity owned retailers that have gone bankrupt and the debt levels that brought them under:

  • Toys “R” Us - $5 billion in debt from a 2005 buyout by Bain Capital and KKR and the real estate firm Vornado Realty Trust

  • Neiman Marcus - $4.8 billion in debt from two leveraged buyouts byTPG and Warburg Pincus in 2005 and the Canadian Pension Plan Investment Board in 2013

  • J.Crew – $1.7 billion in debt, from a buyout by TPG and Leonard Green & Partners in 2011

  • Gymboree – $1 billion in debt from a buyout by Bain Capital in 2010

  • Payless ShoeSource – $838 million in debt from a buyout by Golden Gate Capital and  Blum Capital in 2012

  • Fairway – $267 million in debt, from a buyout by Sterling Investment Partners in 2007

"To be sure, private equity firms will lose most or all of their investment in the bankruptcy, but don't feel too bad for them. The private equity firm isn't on the hook for the debt incurred in the LBO. Moreover, the private equity firm's losses are offset by the management fees it has been charging for all the years prior to the bankruptcy as well as by the gains on successful LBOs," said Georgetown professor Adam Levin.

In Warren’s Medium post she also wrote: “private equity firms raise money from investors, kick in a little of their own, and then borrow tons more to buy other companies. Sometimes the companies do well. But far too often, the private equity firms are like vampires — bleeding the company dry and walking away enriched even as the company succumbs.

Washington has done little to rein these firms in or to ensure that their incentives align with the best interests of the economy. As a result, the firms can use all sorts of tricks to get rich even if the companies they buy fail. Once they buy a company, they transfer the responsibility for repaying the debt they took on to the company that they just bought. Because they control the company, they can transfer money to themselves by charging high “management” and “consulting” fees, issuing generous dividends, and selling off assets like real estate for short-term gain. And they slash costs, fire workers, and gut long-term investments to free up more money to pay themselves.

When companies buckle under the weight of these tactics, their workers, small business suppliers, bondholders, and the communities they serve are left holding the bag. But the managers can just walk away rich and move on to their next victim.”

The Upside

Not all private equity deals are bad for the retail sector. Canada Goose, Dollar General, Burlington Stores, and Restoration Hardware are some of the deals considered a success for the owners and the company alike. 

For example, KKR bought Dollar General in 2007 for $7.3 billion and two years after the buyout it exited the transaction through an IPO in 2009. Dollar General is now one of the most successful retailers in the United States, opening one thousand stores in 2019. Dollar General is even performing well during the pandemic with same store sales up a whopping 18.8% in the second quarter of 2020.

Tricia McKinnonStrategy & GrowthComment