Ian Taylor, UK head of ABN AMRO Capital, which has been consistently active in retail, says of the sector: “Retail goes in and out of fashion. In 1988/89 a lot of fingers got burnt quite badly with deals such as Magnet, MFI and Isoceles (now Somerfield.) But the market has been more stable recently and is not going to be as volatile as it was in 1990, when the house market crashed and a lot of people ended up with negative equity, which is why household deals such as MFI and Magnet went under. The retail mid-market has good growth prospects. The smaller mid-market deals are all about growth and expansion.”
Gareth Whiley of PPM Ventures, a veteran of the sector with deals such as Birthdays Group and Oasis under its belt, both of which were sold in secondary buyout transactions, adds: “Certainly the UK retail market has picked up dramatically over the last two years. While a few years ago there might only have been interest from two or three private equity players in a deal, now there are auction processes with 30 bidders or more.”
One of the reasons for this interest, is that the attitude of the lending banks has changed. “Banks are seemingly more willing to lend higher multiples of debt to retail businesses, which means valuations have gone up. Some are exceeding 10 times EBITDA, which was previously unheard of in retail businesses.” Players have also seen the impressive returns generated by Permira and CVC with businesses such as Homebase and Halfords, and want a piece of the action. But the million-dollar question is whether there is still money to be made in this sector. There is the continual threat of a crash in house prices and a slow-down in consumer spending and if this happens the retail sector will inevitably feel the pinch. Also if you buy something at a multiple of eight times today, it raises the question of what you will be able to sell it for in a few years time. But even in a consumer downturn certain retail businesses will still survive.
Quasi private equity/quasi trade buyers such as West Coast Capital, the private equity vehicle of Scottish retail entrepreneur Tom Hunter, who acquired the share retailer Office and Birthdays Group chain and also attempted to acquire House of Fraser, are having a strong influence on how certain deals in the sector get driven. Most recently the group acquired USC, a retailer of branded clothing and footwear, in a secondary buyout providing an exit for Bridgepoint. Icelandic group Baugur also fits into this category. Among Baugur’s assets are the fashion chain Oasis Group, which owns and operates Oasis stores, Karen Millen, Coast and Whistles, the toy company Hamleys, and most recently Goldsmiths jewellery store chain, which netted Jon Moulton’s firm Alchemy around three times its original 1999 investment.
Baugur also has interests in several companies listed in London, including a 22% share in Big Food Group, as well as shares in House of Fraser and Somerfield. It has also invested in the British real estate development company, LXB Properties, and in Iceland owns a large share in Hagar, the largest food and specialty goods retailer.
Anton Wellenreiter, head of consumer & travel at Barclays Private Equity, says: “There are a few reasons why retail has become more popular in private equity. One reason is simply that there is more private equity money available for investment. Retail is a large and growing sector which will attract more than its fair share of this cash.”He explains that retail is also a sector where it can be easy to see upside potential, for example, by rolling out stores, reducing supplier costs, squeezing working capital or monetising the value of freehold property.
Retailers gain power
In the past, retailers have traditionally been viewed as an inert channel for manufacturer’s products to reach consumers. Manufacturers were the larger, more consolidated players and historically enjoyed more power than retailers. It was the manufacturer which determined the marketing, product design, choice of distribution channel, price and terms of trade. But the roles have reversed, shifting the power towards retail distribution. Retailers have consolidated rapidly and the market share of the top ten global food retailers grew by 20% in 2003 alone, considerably higher than the pace of food manufacturers, according to a report by Rabobank, specialists in the food retail sector.
As a result of this shift in power, the larger suppliers of branded products and smaller regional players are fighting to supply the consolidated retail groups, while retailers have the luxury of picking and choosing between suppliers and driving prices down. Many retailers are also increasing their bargaining power through the use of own-label as a strategic tool. Most renowned for this approach is retail tycoon Philip Green, whose main strategy is to get his suppliers to knock down their prices substantially. It is something he has done aggressively in the past, with the successful turnarounds of UK retailers BHS and Arcadia. Green also recently set his sights on flagging UK retailer Marks & Spencer, but had his £9.1bn takeover proposal rejected.
“The fixed cost of running a retail business is actually very high,” says Gareth Whiley of PPM Ventures. “You have to pay the rent and wages before you can pay off any debt, even if you aren’t making any profits and so when things go wrong these businesses can be worthless and actually become a liability.”
So a private equity firm looks for stable cash flows when embarking on a retail buyout. Seasonality, therefore, is a big issue. Sometimes a business can be difficult to finance if it’s linked to Christmas sales as banks are reluctant to support this type of deal. Woolworths is an example. Kingfisher toyed with the idea of selling it to a private equity house, but there was not enough interest as the chain is heavily reliant on its Christmas sales to boost profits.
Alka Bali of Close Brothers Corporate Finance, says: “Certain VCs are reluctant to look at retail because they are concerned by the cyclicality of the sector and its susceptibility to changing fashion trends.”
Onerous lease obligations can also kill a deal from a bank’s point of view. Many retail businesses are leasehold and banks can be more nervous lending to that sort of business, particularly if it is a business dictated by fashion trends and therefore has unpredictable cash flows. So a freehold property base is always an advantage when approaching banks for debt. Jennifer Harrison, a consultant at Cavendish, says: “Any business with a strong real estate base and tangible assets such as a freehold property makes the lenders feel more comfortable with the investment.”
And often investors are able to make money on a freehold property through a sale and leaseback transaction, particularly as property prices have been rising steadily over the last few years. A sale and leaseback is another way of releasing equity if the business has a number of freehold properties and can enable the private equity investor to pay off debt early on.
Valuation drivers in this sector for a private equity house are a strong brand, a well-defined retail concept, like-for-like growth, an attractive, clean store portfolio, supply chain efficiency, an experienced management team, a robust control environment, a valuable customer database and a consumer credit portfolio. Valuations in the sector can be boosted by a nationwide roll-out capability, international expansion, scaleable back office operations, brand development or repositioning opportunities, asset financing or untapped loyalty programmes.
Guy Weldon, partner at Bridgepoint, says: “What a private equity investor would look for in a retail business is roll-out potential and uniqueness of offer. It is also about real like-for-like sales growth in the existing stores and being ahead of any competitors.”
The recent auction of pet food retailer, Pets at Home, is an example of how popular the retail sector has become with VCs. The first round in the bidding war for this business was rumored to have started with around 30 financial bidders. As a consequence the £230m price tag that Bridgepoint acquired the business for was at a premium to other deals in the sector. Bridgepoint’s acquisition also provided an exit for two minority institutional shareholders, 3i and ICG, which first invested in Pets at Home in 1995 and 1999, respectively.
The reason for its popularity is that it was unique in many ways. “It dominates its sector with very little direct competition. It is cash generative with lots of potential for organic growth and is seen to be not too dependent on consumer spending trends. The size of the deal was such that it attracted a range of VC houses, both mid-market as well as at the larger end. You can see Bridgepoint exiting in a short space of time like CVC did with Halfords and Permira did with Homebase,” says Alka Bali.
Pets at Home was established in 1991 and sells a range of pet foods and accessories for cats, dogs, small animals, fish, aviary and wild birds. It also sells small animals, birds and fish. The business has grown organically and by acquisition to be a leading retailer in UK pet products, a growing market that is estimated to be worth £2.1bn annually. In 1999, the group acquired the 92 stores of its larger UK competitor, PetsMart, from its American parent.
In May 2003, it opened a purpose-built 155,000 square foot distribution centre in Stoke to support the group’s anticipated roll-out programme. As part of its strategy to become an authority on pet care, the group also provides veterinary services through a chain of veterinary practices, most of which are located in Pets at Home stores, and managed through a joint venture, Companion Care, which operates the joint venture veterinary practices.
Guy Weldon says of the investment: “We believe that Pets at Home is an excellent retail business capable of further development both from opening new stores and driving additional contribution from existing ones. At the moment the business has just over 150 stores in the UK and comparing that to a retail outlet such as Halfords, which has over 400 stores across the UK and dominates its sector like Pets at Home does, there is significant room for growth.”
For this reason Weldon does not see any need to expand overseas yet. “Pets at Home has category killer status; it doesn’t have another direct competitor in the UK. I think there’s so much potential in the UK it would be mad to embark on an overseas expansion programme just for the sake of it.”
One of the biggest challenges for retailers is how to maintain a leading position in their domestic market while expanding globally. It is essential that retailers are able to retain their strength in indigenous markets to generate the cash flow required to fuel their international expansion, according to a recent report on retail by Advent International, which has a strong retail investment history including names such as HMV, New Look, Poundland and Vision Express. Successful global retailers think globally, but act locally, recognising what drives their customers in local markets.
Tesco in the UK, for example, is on an international growth strategy following in the footsteps of retailers such as Gap, Starbucks and Wal-Mart in the US; H&M and Ikea from Sweden and Inditex of Spain, which has so far rolled out the Zara fashion brand into 48 countries.
Jennifer Harrison of Cavendish says: “Most of these businesses have strong management teams, but have room for significant growth, which is where the private equity house steps in. What you don’t want is a business like Boots that has fully saturated the market.” New Look, which has been the subject of two buyouts, is an example of a business with significant store enhancement potential. It already had a number of stores in the UK, but there was room for a refining of its store portfolio with potential for overseas expansion. In 1995 founder Tom Singh and his family sold a majority interest in the company to a consortium of private equity investors led by Barclays Private Equity and PPM Ventures. In June 1998, New Look was floated on the London Stock Exchange and Singh retained a 31% stake in the business. The business established itself in France and in 2000 it merged its French retail interests with Mim, a French womenswear retailer, and now operates across France under that name.
New Look is a good example of a retail business that has lent itself well to the skills of private equity players. It was a new retail formula at the time of its launch, which was not working to its full potential and there is evidently still value to be extracted from the business following a take private of the business earlier this year backed by Apax Partners and, Permira, and with reinvestment from Singh.
But the public-to-private phenomenon is something being seen less and less of in the sector. Ian Taylor says: “Pricing has become more difficult and these deals have slowed down. WH Smith would have been a mega deal in this sector. ABN AMRO did look at buying its distribution business a few years ago and wasn’t surprised the due diligence for the deal didn’t come up to scratch.”
In July, Permira pulled out of its £940m attempt to acquire WH Smith because of a £215m hole in the group’s pension plan. WH Smith has since announced the sale of Hodder Headline, its publishing division, in order to make up for some of the shortfall in its pension pot. Hachette Livre, the publishing arm of the French media conglomerate Lagardere, is acquiring Hodder Headline for £210m in cash. Hachette, whose UK interests comprise the Octopus, Orion and Watts publishing houses, will also take on Hodder’s £13m pension deficit.
“When you do a public-to-private you have to ask how you can improve that type of business,” says Taylor. “The problem with M&S, for example, is it is stuck in the middle. It is being eaten away at both ends of the retail spectrum, losing market share to discount retailers such as Ethel Austin and Matalan at one end and designer labels at the other end. The chain needs to reassess its business strategy.”
With the acquisition of Jessops, ABN AMRO Capital entered a specialist niche. Groups such as Dixons and Boots do offer a photographic service but also have other products and don’t have the same specialisation as Jessops. “You have to find a business that has carved out or has the possibility to carve out a niche for itself,” says Taylor.
Value retailing is fast emerging as one of the key growth areas in European retail markets and reflects changing consumer demands. Value clothing retailers focusing on low prices and high volumes are outperforming the market in contrast to many mid market retailers which have had to cope with sales erosion. Financial markets are also starting to give value retailers premium ratings. The trend for hard discounting was pioneered by stores such as Aldi and Lidl in Germany, Wal-Mart in the US and Asda in the UK; its low prices helped it to out-pace high price rivals and gain market share.
ABN AMRO Capital’s acquisition of discount clothing retail chain Ethel Austin is a recent example of such a deal. The group has 271 stores across the UK and has a five year plan which will see 200 new stores open and 2,500 new jobs created. The extra jobs will double Ethel Austin’s workforce from a total of 2,500 between now and 2009 while the firm’s portfolio of stores will grow to around 500.
Ian Taylor says: “Ethel Austin is the kind of retail business we like to invest in; it operates in a growing area of the market, has a proven and successful management team and the opportunity to expand further by rolling out its store programme. The retail sector is increasingly dividing into winners and losers and we believe that Ethel Austin is well placed to take advantage of the continued development of value retailing.”
ABN AMRO Capital has a strong track record of investing in the retail and consumer good sectors. Recent transactions include Jessops (photographic retail), Frank Thomas (motorcycle accessories), G-Star International (jeans and jeans-related distributor and marketer), Oilily (children’s and women’s clothing and accessories) and Champion Europe (Sports apparel.)
But a gradual upturn in the economy may test the resilience of discounters’ strategies as consumer spending power rises. The market may find retailers adjusting their product range as they attempt to attract consumers who want to go up-market. At the same time, formats which had been losing market share during the economic downturn will attempt recovery by offering differentiated products and services.
“The exit is the issue that is still the most difficult question to answer. Where do private equity players get their exit in retail?”, asks Jennifer Harrison of Cavendish. CVC managed a successful flotation of car parts and bike retailer, Halfords and Permira’s Homebase got lucky with acquisitive retailer, GUS, after plans for a flotation were scrapped.
But, says Harrison, very few foreign retailers are interested in buying into the UK as it is such a competitive market and they think there is no upside to investing in retail there. This is particularly evident in the supermarket space, where no foreign investors have been tempted to go after Safeway, for example, when it was up for grabs.
Secondary buyouts remain popular in the sector as there is often more opportunity to add value with store roll-outs and internationalisation strategies. Recent examples are ABN AMRO’s acquisition of Ethel Austin from LDC and West Coast Capital’s acquisition of UK clothing and footwear company USC from Bridgepoint, which is said to have made a return of three times its original investment. Baugur’s acquisition of UK fashion chain Oasis last year also provided a lucrative exit for PPM Ventures.
Andrew Pipe of Berwin Leighton Paisner is optimistic for the future of the sector: “It is interesting to see where private equity will go in retail in the coming months. We have had a long run in the increase in consumer spending so returns and cash flow will look very nice, particularly for those who have been in there for the last two to three years.”
Likely future activity for M&A in the retail sector is in discount, home furniture and furnishings, differentiated fashion and health and beauty. But, warns Ian Taylor, competition for deals will be fierce and bidding wars are likely to ensue. “Retail is back on the agenda but you have to be careful as it can be risky. There is lots of competition and thinner deal flow. Trade buyers are still largely absent and so this will continue to be a big sector for secondary buyouts.”