Oak Hill Ekes Out Return From Duane Reade

After a nearly six-year holding period, the turnover of two management teams and the investment of additional equity to pay down debt and jumpstart a new growth plan, Oak Hill Capital Partners has earned about 1.5x its investment in New York drugstore chain Duane Reade Holdings.

The Stamford, Conn.-based firm agreed to sell the 257-store chain to Walgreen Co. for about $1.1 billion, including debt. The deal, whose purchase price measures out to approximately 11.4x EBITDA, is no doubt a positive development Oak Hill Capital’s investment, which at one time appeared doomed.

Oak Hill Capital acquired Duane Reade in a $700 million take-private transaction in August 2004. On top of about $245 million in equity, the firm layered on debt, including a $155 million term loan and $195 million in senior subordinated notes. Post LBO, the company’s debt-to-EBITDA ratio worked out to about 8.7x, according to sister Web site, peHub.com.

At the time, Duane Reade’s strategy was centered on location rather than attracting and retaining loyal customers, and the company’s growth trajectory was relatively flat. “One thing we observed was that the business had a tremendous amount of opportunity to improve operations,” said Tyler Wolfram, a partner at Oak Hill Capital. Nonetheless, Oak Hill Capital thought it was well positioned to take advantage of ongoing trends such as the aging demographic, prescription drug growth and the shift from branded drugs to generic.

Oak Hill Capital’s first order of business was to replace Duane Reade’s management team. In 2005, the firm brought in Richard Dreiling as CEO. While there, Dreiling replaced much of the company’s management team and put an emphasis on the basics of in-store execution—things like making sure the stores were clean, less cluttered and better on inventory management.

But faced with competition from chains like CVS and Rite Aid, inventory issues and labor expenses, Duane Read’s operating performance had been declining since the fourth quarter of 2001, according to Standard & Poor’s, which kept the company in ‘CCC’ territory for at least two years during Oak Hill Capital’s ownership period. Its highly levered balance sheet only exacerbated the problem.

In late 2007, as recession rolled in, Dreiling was picked off by buyout giant Kohlberg Kravis Roberts & Co. to run its portfolio company Dollar General. “At the time, Duane Reade had about 250 stores, but didn’t really have a point of differentiation or a real strategic mission,” Oak Hill Capital’s Wolfram said.

That’s when Oak Hill Capital brought in John Lederer, former president of Canada’s largest grocery chain Loblaw Cos. Again, most of the company’s management team was replaced to upgrade talent. Lederer developed a next-generation store design and remodeling campaign for Duane Reade, revamped the chain’s merchandizing mix, upgraded its pharmacy strategy, added a line of private label products and launched a loyalty rewards program for customers.

S&P took notice. In April 2008, it upgraded Duane Reade’s corporate credit rating to ‘CCC+’ from ‘CCC’ as same store sales growth and operating margins improved, and were expected to continue to do so. But as the recession worsened, so did the company’s debt burden.

To alleviate that pressure, Oak Hill Capital in the summer of 2009 invested an additional $125 million of equity into Duane Reade as a part of a debt refinancing to keep the company from defaulting. In addition to extending maturities by about six years, Oak Hill Capital used $65 million of its equity to purchase and retire $75 million of the company’s debt. The remaining $60 million of Oak Hill Capital’s equity infusion went to Duane Reade’s remodeling efforts.

Walgreen had been circling Duane Reade for the past year or so, but negotiations for the current deal did not get underway until the end of December. With net sales of $1.8 billion for the 12-month period ended Dec. 26, 2009, Duane Reade has the highest sales per square foot in the retail drugstore industry nationwide, Walgreen said.

The deal is expected to close by Aug. 31, and Walgreen expects to achieve synergies of between $120 million and $130 million in the third year after closing the transaction.

The exit of Duane Reade will be reflected in Oak Hill Capital’s first fund, a vintage 1999 vehicle that closed on $1.6 billion. Last year, the firm closed its most recent flagship fund, Oak Hill Capital Partners III LP, with $3.8 billion. It also closed OHA Strategic Credit Fund last year. That fund raised almost $1.3 billion to invest in stressed and distressed debt.