It’s a classic morality play. Take a wholesome, household name of a business, add some rapacious financial engineers straight out of Mayfair, pile on risky debt, and you have a recipe for barren town centres, unemployment and disaster.
That’s the open and shut case for the demise of UK retail, which nobody doubts is in deep, deep trouble.
A quick inventory of High Street brands which hit financial distress of some kind since the beginning of 2018 includes Toys R Us, Maplin, New Look, House of Fraser, HMV, Homebase, Mothercare, LK Bennet, BHS, Evans Cycles, Poundworld, Debenhams, Monsoon, Accessorize, Top Shop and Carpetright. Throw in the food and beverages industry and you can add Jamie’s Italian, Prezzo, Carluccio’s, Gourmet Burger Kitchen, Patisserie Valerie, Oddbins, Gaucho and Bargain Booze.
Many, if not all, have had private equity owners and all the extra debt that entails.
While a financial sponsor can choose different strategies for leveraging its portfolio companies, their capital structures will almost always be more aggressive than a public company. Any take-private requires paying over the market price for a company, inevitably paid for by adding more debt to the company in question.
All else being equal, that extra debt does indeed make a company more vulnerable to a downturn, cost pressures, or other strains on its business model. Debt juices equity returns in the good times, but reduces flexibility in the bad times.
It’s therefore no coincidence that private equity ownership is a common factor in many of the retail failures so far. KKR and Bain Capital owned Toys R Us, Rutland Partners owned Maplin, New Look was owned by Apax and Permira until sold to Christo Weise (of Steinhoff fame), HMV by Hilco Capital, Debenhams by TPG, CVC and Merrill Lynch Private Equity, Prezzo and Poundworld also by TPG.
You get the picture.
The sponsors weren’t always the ones left holding the baby — but most of the collapsed retailers had some history of private equity ownership, and legacy debt left over.
Advance to Mayfair?
Still, it’s unfair to pin all the blame for the collapse of the UK High Street on private equity.
The retail business that private equity sponsors wandered into when they bought into their portfolio companies in the mid-2000s and after the crisis was far from healthy. Even then, it was clear that online sales would cut into bricks-and-mortar operations, and that major investment would be needed to create a compelling internet presence. Several chains also needed major capital expenditure on their physical stores.
In short, UK retail had plenty of strong consumer brands that weren’t necessarily making the most of their market position. The UK economy was doing well, retail wages stayed low, thanks in part to immigration, and the industry had become complacent. This proved a tempting target for the sponsors.
But far from asset stripping and cutting costs, the traditional private equity playbook, lots of the sponsors in question put more cash into the businesses they bought, opening new sites and expanding aggressively. That meant more debt, and more structural weakness, but it wasn’t obviously the wrong thing to do.
Investing in newer locations with stronger prospects, and integrating these with a credible online presence was one potential way out of the dilemma — especially if it could be combined with disciplined attempts to cut costs.
“The fact that new stores tended to generate better returns and achieved year-on-year like-for-like growth (at least initially) fuelled ongoing demand for more of the same,” said Knight Frank, in its April report on UK retail. “Many retailers, including those in acquisition mode, tended to turn a blind eye to their own ‘ugly tail’. Lease structures in the UK are rigid and it is not necessarily easy to offload under-performing stores.”
That turned out to be the wrong call.
The terms of doing business in the UK's High Streets and shopping centres changed, as did the nature of the competition. Pressure from alternative, online-only channels would grow, and the traditional retailers failed to seize the ground now occupied by the likes of Amazon and Asos. Business rents and the minimum wage went up while the UK economy stagnated. One by one, retailers folded.
Private equity firms compounded the problem as their investment thesis failed to play out. With markets unwilling to offer an exit, some sponsors took cash out using dividend recap deals instead, piling more debt on now creaking foundations.
Yet the gamble could still have worked. The miserable performance of the UK economy since the financial crisis was not a forgone conclusion, and neither were the structural increases in costs through wages, rents and rates.
Private equity by design takes on underperforming companies with certain fundamental strengths, and does indeed use debt extensively in managing these firms. That can place their portfolio companies in a position to win, if done right — access to capital, a decent growth strategy and cost control can help, rather than hinder a company.
Financial sponsors can also be rather more aggressive about revamping a company’s capital structure when difficulties arise. Many of the collapsing retailers, especially the sponsor-owned chains, have opted to restructure their liabilities through a Company Voluntary Arrangement (CVA), in effect, a creditor protection scheme, which, when applied to retail, tends to hit landlords and leaseholders hardest.
It’s been a rough ride for UK commercial property owners facing a wave of these cramdowns, but that shouldn’t be seen as moral issue – leases, like loans, are struck on commercial terms for commercial purposes, and the landlords in question are not exactly innocent little lambs.
Closing stores earlier and pushing for more gradual rent reductions might have proved better than a financial collapse followed by a CVA, but it has the same effect in the end of cutting off the long tail of underperforming stores and giving the business in question a chance to revive with a smaller, more profitable footprint.
Private equity gambled on retail, backed by debt. But, contrary to popular belief, much of this capital was invested in the businesses, and did not just pay dividends. The wager didn’t pay-off, and the private equity-owned firms expanded faster and collapsed quicker than their peers. But this wasn’t inevitable. The retail industry's problems are structural and have hit, and will keep doing so, regardless of whether private equity owners are there or not.