For a brief period last summer, private equity investors in the UK and European retail sector were forced to pause for breath, take stock and re-evaluate what they had been up to for the past few years. The unexpectedness and severity of the credit crunch – together with the continuing uncertainty over what effect it is having on consumers’ psyches caught most of them unawares. Among other things, the shock has brought deal flow to a grinding halt, jeopardised some of the deals made at the peak of the market and increased hold periods dramatically.
Nine months on, some argue that the post-binge hangover is beginning to subside and that a new-found sobriety prevails. In this colder, more clinical mood, general partners are thoughtfully surveying the damage wrought on both market valuations and the trading outlooks of many UK and European retailers.
The recent downgrades to economic growth made by economists and central banks are hardly likely to instil optimism. The International Monetary Fund recently slashed its forecasts for eurozone growth in 2008 to 1.4% and UK growth to 1.6%, and a recent survey from Bloomberg revealed that overall retail sales across the eurozone actually fell in March, with Italy experiencing the sharpest drop.
“Life is particularly tough for clothing retailers across Europe right now, and things have become a lot tougher since Christmas,” said one senior private equity source. “Consumers are worried about what the future holds and they’re having to devote more of their disposable incomes to food and utility bills. Food retailers are proving to be the only resilient part of the retail market at the moment. Whereas people can put off buying a new coat, but they can’t put off buying bread.”
The consensus among stockmarket investors is that the high street is damaged beyond repair and that the sector is one either to avoid or short-sell. The expectation in the UK at least is that consumers will curtail their spending as a result of the credit crunch. This comes on top of very cold spring weather, which caused a particular headache for the clothing retailers. Speaking in March, Phil Wrigley, chief executive of New Look (for which Apax and Permira paid £699m in 2004 but whose £2bn sale is now on indefinite hold), said: “Anyone who doesn’t believe there is significant consumer weakness is on the wrong planet.”
Combined with the continuing scarcity of debt, the effect on both valuations and deal flow has been considerable. Rob Donaldson, head of M&A and private equity at Baker Tilly, says: “The most significant factor affecting valuations in the sector is the lack of availability of debt. If future private equity buyouts are going to have to involve large amounts of equity, it’s going to have a dramatic effect on the returns for investors. Secondly, there’s a lack of visibility about consumer spending. And thirdly there’s the fact both the main market and AIM are all but closed to new listings at the moment.”
However there are one or two positive signs amid the gloom. In the UK like-for-like sales are actually considered to have held up surprisingly well so far – with the exceptions of certain retailers like Jessops and Next. And in Europe there are also signs that the value end of the clothing market is holding up. In March Sweden’s Hennes & Mauritz posted a 28% rise in its first-quarter profit, beating analysts’ estimates, and also confirmed that like-for-like sales across its global network of stores rose 10% in the month of February.
These bright spots have been insufficient to dispel the gloom that hangs like a pall across the sector in the City of London. In the febrile current climate there, investors latch on to any bit of bad news to drive share prices lower. When
“We’re not seeing sufficient transactions to be able to judge whether the private market has followed the public market down,” said Luc Vandevelde, chairman of
Were private market valuations to fall to the same bombed-out level of those in public markets – where price/earnings ratios have collapsed from a high of 24.4x in March 2007 to less than 10x today – there could conceivably be a spate of deals as desperate vendors seek to cut their losses and the bottom-fishers get out their rods. Some private equity investors are also predicting there will be plenty of opportunities to buy “distressed” retailers on the cheap.
Richard Morley, director of
Richard Mathews, head of consumer and leisure at HgCapital, said: “Either the public market investor or private market investor has got pricing wrong; they can’t both be right. Assuming the public market has got it right then, at some stage, private market valuations will have to adjust if deals are to get done. This will take time, but I think we may be entering a very interesting time to invest our clients’ money in retail assets.”
Vandevelde said: “I think that 2008 and 2009 are going to be vintage years for private equity firms involved in the retail and consumer sectors. In the current environment, I suspect that generalist private equity players – those that too reliant on financial engineering to generate returns – will struggle to make deals stack up. However I think specialist firms that really understand the retail business and which have the ability to make operational and management improvements, could do extremely well.”
Vandevelde, who was chief executive of Marks & Spencer up until 2003, believes that the best opportunities in the European retail space are to be found in countries that have avoided the exaggerated housing booms and busts that have been seen in the UK and Spain. He said that CCP’s most favoured nations and regions for investment in the retail sector are currently Germany and Scandinavia. Next on his shopping list are Italy, France, Belgium, Holland and Switzerland. Vandevelde said that his least favourite countries for potential deals in the short term would be Spain and the UK as he believes the consumer crisis is going to be worst there.
Jacques Callaghan, managing director at London-based investment bank Hawkpoint agrees that, in view of the current very cloudy outlook for UK consumer spending, Continental Europe is going to present the most interesting opportunities in the near term. He said: “I see plenty of opportunities on the Continent.”
He would not comment, however, on the possibility that the Galicia-based Inditex Group (parent of multinational fashion chain Zara) might become a target for private equity, or the speculation that Düsseldorf-based supermarket and cash & carry group Metro might sell its Kaufhof department stores and 40 loss-making Real superstores to private equity bidders.
“I would say there are more opportunities on the Continent,” Simon Laffin, industrial adviser at CVC Capital Partners. “That’s because private equity is less developed in retail than in the UK and because the retail market is much less concentrated, which means there are more targets. Mid-market private equity players should be able to find plenty of targets that are within their sweetspots in continental and Eastern Europe. By comparison, the UK market is quite well shopped by private equity.”
The UK market is already so mature that secondary and even tertiary buyouts have become the norm in retail. On the Continent it is easier for investors to get in at the ground floor with primary deals. Another plus is that Continental retailing remains a much more fragmented business than in the UK – less conformity on the High Street spells greater opportunities for buy-and-build strategies and for investment in strong concepts that have the scope to be rolled out on a national or international basis.
Retail was a comparative latecomer to the private equity mainstream. While a few mid-market buyout houses such as Graphite Capital, PPM and Isis Equity Partners did some deals during the 1990s, it only really became a fashionable area in about 2003-2004.
Before that time many banks and investors were put off by high levels of operational gearing in the sector: many also had got their fingers burnt on the disastrous LBOs of both Magnet and Gateway in 1989. The cyclical nature of the UK economy – which experienced a major boom in the early 1980s, only to be followed by a massive bust in the early 1990s – only intensified their wariness of the sector. Baker Tilly’s Donaldson says: “The view was that piling financial leverage onto operational leverage could be a pretty lethal thing to do.”
Donaldson believes that the banks were able to soften their stance after the likes of Sir Philip Green and Sir Tom Hunter showed what could be achieved soon after the Millennium and also because of the economic stability which Gordon Brown ushered in when he granted autonomy to the Bank of England in 1997.
It wasn’t long before private equity started to fall in love with the sector, particularly with the opportunities to unlock value from retail companies’ property estates (especially in the larger deals), the steady income streams retailers can provide, and the way business models can readily be rolled out nationally and internationally.
According to Hg’s Mathews, the sweet spot for private equity investment in the retail sector really came in 2004. “The transaction that really ignited private equity interest in the sector was Pets at Home,” he said. The pet shop chain was acquired by Bridgepoint for £230m when the mid-market buyout house bought and enlarged on 3i’s 23.6% stake.
“That deal occurred around the time of a number of other retail deals – including Montagu Private Equity’s acquisition of Maplin Electronics [Graphite Capital had bought Maplin for £41m in 2001 and sold it again for £244m in 2004],” said Mathews. “From that point on, deals in the retail sector were driven by a rising tide of consumer spending. Banks’ prejudice against the sector diminished. It was a pretty good time to be investing as valuations were still relatively modest (although they didn’t always appear so at the time!).”
Post-credit crunch it seems the banks rapidly rediscovered their former scepticism towards the sector – and many other sectors, for that matter. Mathews says bank credit committees are increasingly just saying no when it comes to lending to retail deals – particularly if their bank has reached a certain level of exposure to the sector. The fall-out from Kohlberg Kravis Roberts and Stefano Pessina’s £11.1bn acquisition of Alliance Boots last year is also having a big impact. The debt used to fund that deal has yet to be syndicated, and it is cloying up the balance sheets of banks including lead arranger Deutsche Bank.
Despite all this negativity it is worth pointing out that retail deals have not totally dried up. In early April 2008, Barclays Private Equity sold a majority equity stake in the French home furnishings retailer Maisons du Monde to Apax Partners and LBO France. With annual sales of €237m, Maisons du Monde has 175 outlets in France, Belgium, Spain and Italy.
Robert Daussun, LBO France’s chairman, said: “This clearly demonstrates that investors and financial providers can indeed transact on quality deals benefiting from a clear strategy, strong growth and proven management team. This marks the return to strong fundamentals”. Also in Europe, BC Partners acquired a majority stake in the Turkish retailer Migros for €964m in February.
The debt squeeze
However what is clear is that securing debt funding is a much more onerous task than it was even a year ago. When Exponent Private Equity was trying to take over the High Wycombe-based bed retailer Dream for a reported £225m earlier this year, sources say it approached 40 banks. Of these only three were prepared to lend. Yet Mathews sees that as a positive. He says: “The point is that it was a pretty full valuation, in a difficult debt environment, and in a difficult sector since beds are ‘big ticket’ items. The message is that good quality assets will always find a buyer.”
Other deals that have gone through since the liquidity squeeze struck have included Borders, which was snapped up for £20m by Luke Johnson last September. Johnson, chairman of Channel 4, acquired the UK arm of the bookseller through his private equity vehicle Risk Capital Partners (RCP), for £10m with an additional £10m payable depending on performance.
Anne Hoffmann, an investment manager at Graphite Capital, said: “Kurt Geiger has a very strong and capable management team, and is firmly positioned at the luxury end of the market which we feel is a good place to be. We think it has a tremendous opportunity to consolidate its position as the leading luxury branded shoe retailer.”
It seems likely that the lower end of the market – deals in the £5m to £50m range – will be the least affected by the credit crunch. NBGI’s Morley said: “We operate in the lower to mid-market, where there is a different dynamic. The credit crunch has not had so much of an impact in this part of the market as it has for mega-buyouts along the lines of Boots.
And there is also some remaining optimism among practitioners that, if and when the debt taps are switched back on, the retail sector is going to be a great place to shop for bargains. Hawkpoint’s Callaghan says: “I predict that once there’s more certainty about consumer spending and debt becomes more readily available again, then quite a few retail businesses are going to come up for sale. There’s a lot of pent-up supply there. My prediction is that this will happen in 2009.”
Morley said: “The number of opportunities has definitely died back, partly because stock market valuations have been so low. But owners looking for an exit will only be able to hold off for so long, and within 12 months some retailers are going to have to come to market either because somebody feels they have to sell or because they’re in a distressed situation. The environment over the next 12 months will hopefully create some good buyside opportunities. If our competitors are becoming more cautious, it hopefully creates some interesting opportunities for us to buy better.”
Clutching at straws it may be. However, Ian Macdougall, a retail analyst at Blue Oar Securities, points out that no retail downturn lasts forever. He also points out that retailers are much more sophisticated in their approach to logistics and supply-chain management than they were in previous consumer recessions – meaning fewer will be at risk of collapse. He says: “It is highly implausible that we are faced with a retail economy permanently in decline.”
Trouble at till
As consumers reign in their spending, the high street is bracing itself for a volatile few months, with many high-profile businesses, some backed by private equity, are expected to fall by the wayside.
Weakening house prices in countries such as Ireland, the Netherlands, Spain and the UK are already affecting consumer confidence in these markets, and the effect on consumer spending is likely to worsen as house values slide. Yet high street spending in less residentially-challenged markets such as Scandinavia, Germany, Italy and France are expected to be much more robust.
Against a backdrop of the weakening consumer demand and ultra cautiousness from the banks, some of the flakier deals put together at the height of the private equity’s short-lived love affair with the retail sector are already unravelling.
In January, Hermes Private Equity wrote off its investment in the UK-based discount booksellers, The Works, which it acquired in a £50m deal three years ago, after the retailer was forced into administration. Administrators Kroll have since closed 85 of The Works’s 210 stores, resulting in 450 job losses. The bookseller is rumoured to be on the receiving end of an opportunistic £15m takeover bid from Endless, a Leeds-based private equity house. Shoe shop chain Dolcis, backed by Epic Investment Partners and Scots entrepreneur John Kinnaird, also went into administration in January.
In March and April there was a fresh round of casualties on the high street. Ethel Austin, a value womenswear chain renowned as a pioneer of cheap chic and which was acquired by ABN Amro private equity for £122m in 2004, went into administration. Earlier that month, Sleep Depot, a bed retailer, and the toy chain Toyzone, both also called in the administrators.
Robert Donaldson, head of M&A and private equity at accountants
In the case of the bingo-to-bookies business Gala Coral, existing backers Permira, Cinven and Candover have been forced to stump up more cash to avoid the banks pulling the plug on the business. The company was bought for £1.24bn by Candover and Cinven in 2004, with Permira stepping in to acquire a stake in 2005 at the higher valuation of £1.89bn. It has been reported that these three buyout houses backers have stumped up an additional £125m of new equity in exchange for the banks loosening their convenants and enabling £83m of senior debt to be paid off.
One reason for the severe shortage of buyers of debt is that approximately £8 billion of debt used to fund the Alliance Boots mega-buyout last year still remains unsyndicated. Anne Hoffmann of Graphite Capital believes this will mean that mezzanine finance and “good old-fashioned debt instruments” are going to play a bigger play a bigger part in future retail deals. She says: “The more marginal deals simply won’t get funded, but I think very good deals will remain able to do so.”
Other private equity deals in the retail sector that are showing signs of strain include Fat Face. This active outdoor clothing retailer was acquired by Bridgepoint for £360m in March 2007 at the peak of the debt-fuelled buyout frenzy. The company’s senior debt has been quoted at 60p in the pound, while its junior debt is trading at 40p, suggesting that investors believe the company is worth less than its total borrowings. This is something which can drastically reduce a business’s freedom of manoeuvre. However, Bridgepoint denies that Fat Face is experiencing trading difficulties and insists revenues should rise by 10 per cent in the year to March 2008.
Corteciel, a Spanish clothing retailer with 1,100 stores, which was acquired by PAI, Permira and CVC in 2005 finds itself in a similar position. To the dismay of some Permira insiders, it was recently written off as a “zombie” company by Edward Eyerman, head of European leveraged finance at ratings agency Fitch. Cortefiel’s senior bank debt was recently quoted at 67 per cent of its par value, which would also suggest that its equity has become worthless.
On a much smaller scale, Ossian Retail Group, owner of the Internacionale fashion chain and the Au Naturale interiors chain, is struggling after costs got out of hand last year. Ossian was acquired in a £45m buyout by the Glasgow-based private equity house Penta Capital, Graphite Capital and Bear Stearns in 2006. Distressed debt player Agilo recently bought £25m of debt provided by Barclays at the time of the buyout amid reports it plans to dismember the business.
Richard Morley, of NBGI private equity, says: “There was some frothiness in the market [for retail M&A] over the past couple of years and some relatively high prices were paid. Obviously, this creates a degree of risk in a downturn. While the better retailers with strong niche positions will continue to perform well, even if consumer spending weakens, I think that weaker businesses – and especially those that are overly geared – are clearly going to struggle.”
At the best, Morley predicts that heavily indebted retailers will have to rein in their growth plans. At worst they could go the same way as Icoseles/Gateway and Magnet.