Private Equity Ownership: A Good Deal For Retailers?

The high street is in a crisis. Already this year, 15,000 jobs in the retail sector have been axed, or are under threat.

In January, 2,000 jobs were lost as Jessops fell into administration, 4,190 jobs went at defunct DVD shop Blockbuster, and another 4,123 jobs were hit when HMV went to the wall.

This week saw fashion chain Republic hand over the keys to Ernst & Young, putting another 2,500 jobs at risk.

Some have drawn a line between the retailers struggling to survive and those with private equity (PE) owners.

In January 2012, Past Times and La Senza both failed, (although La Senza is in the process of hopefully being turned around) costing 1,000 and 2,600 jobs respectively; in February Peacocks/Bon Marche closed, axing 9,600 jobs; March saw Fenn Wright Manson's 17 stores and 62 concessions close, costing 350 staff their jobs; in November 2012, Comet collapsed, culling 6,500 staff; and Walmsley's also closed, costing 105 staff their jobs.

This month's failure, Republic, was also PE-owned. So is there any correlation between the two? Or is there more joining the failed retailers together?

It's worth analysing why the retailer/PE partnership exists in the first place.

Many of the retailers acquired by PE in recent years reached out to them because they were struggling. Some were even already in administration, meaning other forms of traditional funding weren't available to them.

Comet fell into administration after its PE owners Op Capita failed to turn the business around in 2012

From the private equity houses point of view, they are more than willing to stake money on improving these businesses, because they can usually buy these distressed retailers at bargain basement prices.

"Bank funding alone is often not sufficient in a retail growth story as there needs to be equity investment as the business is reinvesting its cashflow in growth," said Rob Donaldson, head of mergers and acquisitions, and PE at Baker Tilly.

"The public markets had only limited appetite for young retail businesses and so were not a sufficient or even appropriate source of funding until these businesses mature."

What is private equity?

Private equity consists of investors and funds that pay money directly into private companies or buy them outright. For the company being invested in, the extra cash can be used to fund new technologies, expand, make acquisitions, or strengthen a balance sheet.

The other potential benefit is PE financing does not have interest payments associated with it, according to Tammy Smulders, founder and managing director of SCB Partners.

"They will use also their business contacts and plans to increase profitability to secure further debt financing from banks or hedge funds. Often this funding would not have otherwise been achieved," she said.

"They would also have offered their business skills, combined with the funding, providing a good package for the retailers."

An according to Nick Hood, business analyst at Company Watch, the last few years also saw a mood of "wildly excessive optimism about the skills of private equity players and a failure to understand that the retail market can go down as well as up".

"They were the turnaround kings, who could transform base business metal into retail gold," he said.

And in many cases, retailers would have failed without PE backing.

"PE owners have a more radical approach to solving business problems and a willingness to bolster existing management with retail specialists," said Hood. "They can invigorate tired retail offerings and blow away old-fashioned ideas which have been holding back the business."

Hobbs, owned by 3i, is a good example of a retailer who has a successful relationship with its private equity owners

There are downsides to using PE houses however. A typical PE ownership lasts between two and seven years – potentially enough time to turn around a business, but depending on the economic situation at the time, even that may not be long enough.

"To effect a turnaround you need two things: time and money. PE owners provide both. What they cannot do, however, is change macro market conditions and a number of retailers have continued to find life more difficult than anyone envisaged,” explained Nick O'Reilly, insolvency partner at the chartered accountants HW Fisher & company

The medium-term timeline also means money for some longer projects may not be given priority. "Their short-term ownership means that investment in infrastructure, which might take years to generate a return, will not be top of their priority list," O'Reilly added.

PE owners can also be seen as quite demanding, expecting the management team to deliver on their promises. But the biggest concern is the amount of debt introduced into PE deals.

"These deals…need to be structured with sufficient robustness to allow for periods of underperformance. This clearly has not always been the case," said Baker Tilly's Donaldson.

Aggressive business plans against stretched balance sheets can cause problems if an upturn isn't apparent straight away.

In the case of declining businesses in dying sectors, these debts can become burdensome on the company and even increase the likelihood of failure.

"(Some PE houses) load up retailers with huge debts which can only be serviced by success," said Company Watch's Hood.

"The financial profile is so vulnerable that any hint of trouble makes key stakeholders like suppliers, credit insurers and landlords extremely nervous, and their fears are made worse by the lack of open financial disclosure caused by the complex corporate structures that are the norm for private equity."

And SCB Partners' Smulders warned it was imperative for companies taking on PE ownership to ensure the two parties' interests and goals are aligned from day one.

"The PE partner will take at least one, and typically more, board positions, and may have certain special veto rights on the board," she said.

"It is essential that if a retailer is taking on a private equity partner, their expectations are aligned upfront."

Case study: Iain MacRitchie, chairman of Hobbs

In our opinion, there is no link between failing retailers and those that are backed by PE. As recent cases highlight, failure is being driven by business models that have been unable to keep up with the rapid changes in consumer demand and the impact of a continuing flat economy.

At Hobbs we have grown despite the economy and have a number of brand, multichannel and product developments being launched in 2013 and 2014, all driven by a highly talented and experienced team.

PE investment is an initiator of change and sets an effective pace. Their network of contacts, experience, skills and hands on support helps construct effective business plans and provides the motivation and encouragement to achieve.

I have worked with a wide range of PE funds over 15 years and found their default to be consistently constructive and transformational. They also provide flexible capital that can be invested in a variety of ways, for example with Hobbs in consumer research and rebranding.

The only cons of PE, common with many other financial institutions, arise when too much debt is taken on by companies. In the current economic climate this excess has become a constraint to growth and development. However, in my opinion and experience the pros far outweigh the cons.

I don't think any of the recent failures would put existing owners off PE buyers. The PE funds active in the market understand what is required to build an effective business plan, taking full account of the challenges of the current economy and operations and helping support the management team to implement the required changes.

3i has actively supported and encouraged the company and brand to realise its full domestic and international potential. They have provided ongoing investment and conducted a comprehensive programme of consumer research and subsequent development of the brand, product range, store estate, e-commerce capabilities, management team and infrastructure.

They have been patient, considered and now rewarded with a consistently strong performance and a pipeline of developments, which will transform the business further and faster on an international stage. I have had many years working with private equity and would commend 3i very highly for its ethics, talent and long term commitment.

So if you're a struggling retailer, should you think twice before taking money from a PE house? Not necessarily.

Almost all of the commentators we spoke to said the PE-owned retailers which had failed did not go to the wall because of their owners.

"In the case of businesses like HMV, Jessops, Blockbuster, Clinton Cards etc, these were obsolete businesses. E-commerce, downloads, etc. have put them out of business. I'm not sure PE is to blame," said Smulders.

PE money may come with fewer strings attached than a merger with a rival, but it's important to pick an investment house that knows a lot about the retail business, said HW Fisher & company's O'Reilly.

"The recent flurry of failures of companies who've taken the PE shilling does not mean those investment is always bad, but each private equity investor offer must be judged carefully on its merits," he added.

Simon Whitney, partner at law firm SJ Berwin agreed that it was important to seek out the right backer, adding: "PE firms have a lot to offer companies, and those with specific sector experience should be able to help management to navigate an extremely challenging and uncertain market."

Retail successes and woes with PE ownership

We asked our experts to name some examples of companies who had fared well under PE guidance; some of the more popular ones included Hobbs, Fat Face, Jimmy Choo, Poundland, 99p stores, Wiggle and Go Outdoors. R Capital's turn around of Little Chef was also highlighted.

And one specialist told us it was unlikely that tea and coffee merchants Whittard would still exist if it hadn't been for its rescue by EPIC in the run up to Christmas 2008.

And when we asked for the top cases where PE ownership may not have worked so well, two names dominated - Republic was cited as an exampled where a deal was "poorly timed and priced, contributing to its demise", and Op Capita, the former owner of Comet.

Although Comet was arguably already on a downward path, several insolvency specialists have asked questions about what happened to the £50m dowry given to it by its previous owners, Kesa.

"The new owners took security over its assets to secure the lending they provided, which restricted the chain's room for manoeuvre when the going got tough. They also separated out the profitable product insurance business, which had been a source of support for the ailing retail business," explained Company Watch's Hood.

"While entirely legal and not unusual within the PE world, these tactics left Comet with little chance of survival when the going got really tough."

Opcapita also failed in its mission to turn around white goods retailer MFI in 2008.