The experts were right. They predicted a downturn in consumer spending, and this is exactly the situation retail finds itself in. As evidence, the latest figures released by the Confederation of British Industry show 47% of UK retailers are experiencing a decrease in sales, a reflection of the anxiety over house prices, interest rates and tax increases.
Naturally, this is affecting private equity, which came to the sector late, but which, since 2002, has pumped in billions of pounds, as shown by the data published by Centre for Management Buy-Out Research (CMBOR.) The thing that is most striking about the figures is not the number of deals that have been completed so far this year compared to last, but the total value of the deals, which is best displayed in the graph below entitled Trends of buyouts/buy-ins, 1985-2005.
The consumer spending slowdown has not been as severe as some of the more pessimistic observers were predicting at the beginning of the year, and in terms of deal flow, there hasn’t been a huge drop-off. Twenty-one MBOs and MBIs were completed in the first six months of this year, just less than double the figure for the whole of 2004 (47), so not too far off the pace.
A very different picture emerges when looking at the total value. Last year’s figure of £2.449bn mark it out as a particularly good year. For the first six months of this year, the total has reached £254.6m, around 10 times less. But what does this say about the retail sector?
One argument could be that 2004’s figures were inflated by some larger than usual deals. Two of the biggest of the year was the take private of UK high street clothes chain New Look, which was bought by Apax and Permira in a £700m deal in March. In October, DFS, the British furniture retailer, was acquired by its founder in a £507m transaction. By comparison, the largest MBO/MBI to have taken place in the opening half of 2005 was the £55m acquisition of DCK Concessions by Bank of Scotland from Barclays Private Equity.
This year isn’t over yet of course, and it’s still possible that a number of bigger deals could be completed, like Somerfield. Apax and Barclays Capital are currently hoping to get the UK supermarket chain for around £1.1bn, and will now have to do it without the help of Baugur after the Icelandic investment group withdrew because of legal action being taken against a number of its employees, including its CEO.
Under different circumstances, 2005 could have been another bumper year; Apax came close to buying Woolworths in April for £837m; KKR and Carlyle were rumoured to have been considering launching a bid for Boots at around the same time, a company Investec valued at up to £1.3bn; MFI Furniture, which was reportedly being eyed up last year by Cinven, CVC, Permira and Texas Pacific Group, was again linked with private equity bidders in March this year (Investec estimated a bid of around £1.1bn); and also Kingfisher, the home improvement group which owns B&Q in the UK and Castorama on Continental Europe, was subject to speculation about its future in May.
No more good deals?
So despite a downturn in consumer spending, a flurry of speculation as to possible acquisitions by private equity continues. Clive Black, a retail analyst at Shore Capital, thinks such rumours will continue: “A whole raft don’t happen because people cannot see how more value can be squeezed from leasehold-based companies that are being pretty well run anyway. Takeover stories are the last bastion of attempts to raise share price.”
Despite the cynicism, Black’s point is that private equity funds will find it difficult to add value to a successful company; a view which is common among retail GPs. Black continues: “I can see a lot of speculation, but I expect actual deal flow to decrease. Of course the downturn in the market will provide opportunities, but the question is, ‘have the best deals already happened?'”
Mark Charnock, retail analyst at Investec, expands on this point: “A few years ago you could pick up a company and make money without doing too much to it. Now you have really got to manage the business to extract value from it.”
The search for new opportunities in a sector which has seen so much activity and so much money poured into it since 2002 is the fresh challenge for those funds operating in the area. There is a definite sense among many GPs that most of the best deals have already been done, and are either still being held in portfolios or have been floated or sold. Andrew Gray, a partner at Graphite Capital, says this means retail companies have to have a story: “It’s not enough to be a great company anymore, there has to be a long-term vision and plan.” This, he says, makes retail investing especially challenging: “We are still seeing a number of deals being done, and everyone is looking at everything, but there are less initial opportunities coming along. This has meant that secondaries have become much more accepted which has created a lot more activity. There are more people in our market chasing deals and there isn’t going to be an increase in the number of deals out there and this is worrying because it will push prices up.”
Divorced from reality
That only £245.6m has been invested in retail in the first six months of this year could indicate investors have realised some people were paying over the odds, and have decided take the sensible course and hold back until the market improves. This certainly seems to be Graphite’s strategy, which sold Jane Norman, the UK women’s clothes chain, to Kaupthing Bank and Baugur Group in July for £117.4m, making a 2.9x return on its two-year investment. Gray says: “We have always been cautious of retail, and have always looked to see what the concept and growth profile ahead is. Generally it’s been over-priced, and this is partly because the banks have come into it quite aggressively but that is changing a bit.”
There is little doubt that prices have risen over the last few years, due to the increase in competition between funds and the availability of debt, but Charnock says retail valuations are beginning to come down due to banks becoming stricter and a number of funds moving out of the sector. “VCs spend a lot of time kissing frogs and so they are now looking at areas where there are some princes,” he says. CMBOR backs this up, with data showing the UK healthcare sector has seen investment activity more than double to £3.3bn, unsurprising considering the UK Government’s commitment to spending in this area.
While retail valuations do appear to be coming down, although this is based on anecdotal rather than empirical evidence, they are decreasing slowly, despite the current predicament of the sector. Richard Matthews, a director in HgCapital’s consumer team, says: “Private equity and banks stop doing these deals not when they get cautious, but when they get bitten. Some banks will always put money on the table and some funds will always use it.”
HgCapital is without any retail companies under its management, with the exception of the products arm of The Sanctuary Spa, something Matthews says is down to being picky: “The trick is to be highly selective. When the economy is doing very well it’s a very forgiving time on the high street because people are spending and putting money on their credit cards. Nowadays you are going to get hurt if you invest in an average retailer. We are bearish about the economy. There will be a big difference between the winners and losers, with no-one in the middle.”
HgCapital has produced its own statistics on the sector, and they do not make for very comfortable reading. For example, prices paid by private equity investors between mid-2004 and mid-2005 have averaged a premium of around 25% to quoted market comparables; comparable transactions between mid-2001 and mid-2003, averaged out at the same rating as the quoted market. In 2004, 75 retailers were bought by private equity funds; in 2002, just 32 were. In 2004, the share of new private equity investment taken by the retail sector was 26% versus 9% in 2002. HgCapital argues that, over the last 12 months, the prices paid by private equity investors for businesses in this sector have become divorced from reality, and this assertion is supported, the firm claims, by a number of recent transactions that are underperforming against the aggressive growth forecasts on which the valuations were justified.
In times of a high street downturn, even good companies can find themselves in trouble, and Maplin has been a particularly high profile one. Bought in September by Montagu Private Equity from Graphite, Maplin, an electronics retailer, is reported to have broken its bank covenants. A £240m deal, Graphite made a 9.6x return on a three-year investment; it was, according to Gray, a very good company. It had 20 bidders when it was put up for sale in the summer. By May of this year the company was struggling. Maplin, it was felt, had a good story, and it was leveraged on the basis that its sales would continue to grow; unfortunately for the business and its backers, it didn’t. The leverage was high, and around 14 new stores had been opened, but the increase in sales (said to be around 10%) has not been enough to fend off the high street downturn. With consumer confidence dipping, electronics items find themselves lower down the list of shoppers’ priorities.
Over-leverage
Maplin isn’t alone in going through tricky times, UK discount clothes retailer Ethel Austin is also reportedly speaking to its banks about its debt levels. What unites these companies, and most retail GPs are of the opinion there will be a handful more of these cases, is the high debt multiples. The aggressive lending of the last 18 months, combined with the flurry of interest in the sector (best displayed by the Pets at Home auction attracting 38 bidders), has meant a lot of firms have been paying a lot of money on acquisitions and have been heaping significant amounts of debt onto them. As Andrew Meehan, chief executive of Gordon Brothers’ European expansion programme, says: “Retail is essentially a fixed cost business. While layering on debt has the effect of de-risking the equity holders’ position, it increases the operational risk of the business by adding to costs. Therefore relatively small sales reductions can affect the bottom line seriously.”
And the banks are said to be taking this on board. While debt multiples still remain historically high, lenders are becoming more concerned about risk. Steven Silvester, a director of Barclays Private Equity, says: “Some of the banks are being a bit more cautious, influenced by the overall economic and sector outlook. It’s harder for a bank because they can’t tell what’s going to be a winner and what won’t be.”
The impact of the downturn will take time to hit, and evidence suggests the banks are starting to pull their horns in. Lorenzo Russo of Change Capital Partners says: “There have been a few deals over the last 12 to 18 months that have been very difficult to justify in terms of price, but now, because of the consumer slowdown and the banks becoming more prudent, the market is being pushed into more realistic valuations.”
Challenges
“One of the main challenges over the coming months and years,” says Silvester, “will be making sure you don’t get it wrong while the market is tougher than it has been, ie, watching your back a bit.” This careful approach is inevitably tied to exits, and there have been some raised eyebrows as to who is going to be able to exit investments that have been made over the last 12 to 18 months.
Silvester continues: “The exit market was quite a hard story to tell a few years ago, and the last year exits didn’t look to be a problem, but the future is hard to predict. Good businesses that have good stories to sell will be able to find buyers. Those that haven’t will obviously find it harder. As a result, deals are being done on a more cautious basis.” Russo says: “Consumer expenditure will not grow at the same pace as it has done over the last three or four years. The focus now should be on improving the performance of businesses.” Change Capital is in a somewhat unusual position as the firm is a retail specialist; whereas the larger firms can reduce their exposure to the sector, Change Capital doesn’t really have a choice. “The slowdown has not really affected us much. We are seeing deals being done at more realistic valuations, so it’s healthy that supply and demand has evened out.”
For Graphite’s Gray, this marks a crucial point for private equity in retail: “As private equity investors, we are rewarded by making more money than we put in, and so we have to source good opportunities and maintain our standards. The challenge for retail investors is there to invest their money sensibly.”
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