The difficult macro-economic conditions of 2008 pervaded 2009, with consumer discretionary spending on the decline.
With a few notable exceptions (Wal-Mart, Urban Outfitters and Buckle), many retailers have retrenched, focusing on core business lines, distribution channels and markets. Driven by consumer pessimism, the market has accorded historically low valuations (4-5x EBITDA or lower) to retailers Ã.‚¬" some valuations barely account for the cash on retailers' balance sheets.
Although the industry is troubled, there are many strong retailers in need of a capital infusion to ride out the storm. In the current constricted credit market, there is limited debt/ equity available. Retailers seeking capital need to consider alternative sources. Private equity firms, once relegated to the LBO market, are now looking for alternative ways to deploy unutilized capital, focusing on distressed investing, loan-to-own situations, private investments in public entities (PIPEs), partnering with corporate buyers and minority investments. With creative structuring available, retailers can accumulate capital without ceding majority ownership, governance and business strategy to a PE firm and without covenants traditionally associated with various forms of debt.
Despite turbulence in senior debt markets, middle-market financings are being completed due to the willingness of private equity groups to "overequitize" transactions and engage in creative financings - thereby deploying the vast amounts of cash raised in recent years. In 2009, total PE capital available in the United States will total about $262 billion (Source: Preqin Ltd); there is still plenty of money in PE coffers that needs to find a home. And PE has never shied away from the retail industry, as data from Preqin points to retail as the 8th biggest sector globally for PE buyout deals in 2008. A total of 91 retail deals with an aggregate value of $9 billion were inked during the year.
The attraction to the retail market is clear:
*Retail is tangible and easy to understand for many investors.
*Retailers with attractive unit economics can drive predictable growth through planned store openings, which interests PE firms and institutional investors.
*Furthermore, some retailers also possess real estate that can be monetized.
*Retailing is never going to go away completely. Even though 2009 may be very tough, if history is any guide, consumers will revert back to normal spending levels. We could still have a $3 trillion retail sector.
*Retailer earnings have been hurt meaningfully and quickly by the drop in sales and their large fixed store rents. Retailers are actively managing inventories and decreasing cost levels. When the consumer returns and the top line grows, earnings will rebound equally dramatically as when they fell -- demonstrating the power of leverage when inventory and expenses have been honed down.
Yet, for all of the PE interest in the sector, few deals have been consummated in 2008 and 2009. Retailers want to keep ownership, governance and strategy decisions in-house, therefore forgoing a capital infusion. Still others have noted that the cost of outside capital is at historical highs, making it less appealing to accept money unless absolutely necessary. Retail boards, such as that of Charlotte Russe, have been reticent to accept buyout bids on the premise that PE is taking advantage of abnormally low valuations
However, buyouts aren't the only terms under which PE operates. To generate returns on their idle funds, some have been willing to invest with terms and structures more attractive to borrowers than typical long-term equity solutions. Where they might be unable to take a lead role in the acquisition of companies, many of these equity sources are entertaining creative applications alongside strategic buyers.
PE'S Creative Structuring
MINORITY INVESTMENTS: More private equity firms are making minority investments in retailers that are looking for capital to expand or restructure operations, pay down debt with burdensome covenants, enter new markets or finance a major acquisition without a change of control of the business.
In March 2009, American Apparel Inc. obtained an $80 million investment from Lion Capital LLP. American Apparel said it will use proceeds from Lion Capital's investment to retire the outstanding amount under its second-lien credit agreement. Remaining funds will be used to lower the outstanding balance under its revolving credit facility, repay part of a shareholder note, pay fees and expenses related to the deal and for working capital purposes.
JUST-IN-TIME EQUITY, FUNDING ONLY AS NEEDED: PE can sponsor companies with modest original equity infusions, enough to buy or build the current project, with commitments to provide additional equity as the business grows. This sponsorship allows the company to pursue projects with confidence in its financial capability and minimizes dilution to the management's equity position and incentives.
EQUITY-PLUS-VENDOR FINANCING/PARTNERSHIP: This financing mechanism has become increasingly popular, especially with apparel manufacturers and vertically integrated retailers that are cash constrained. These transactions may prevent a supply issue or bankruptcy filing for the company by allowing the vendor to become an equity holder or strategic partner. The vendor might improve payment terms, lower sourcing costs, reduce outstanding payables due or provide cash as it seeks equity upside, a high interest rate loan or increased manufacturing volume down the road. After the vendor is secured, PE firms can invest in a company that has secured its sourcing operation and maximized its efficiency.
In February 2009, Liz Claiborne announced that it was turning over its sourcing operations for $83 million to global apparel exporter and supply chain specialist Li & Fung as a way to raise capital and improve its supply chain. The move means that Liz Claiborne may be ceding some control on its future sourcing options, but the company has raised much needed cash in the near term and will likely save money by having a more consolidated approach and potentially will be able to bring merchandise to market more quickly.
MEZZANINE CAPITAL: Mezzanine capital refers to subordinated debt or preferred equity securities that often represent the most junior portion of a company's capital structure that is senior to the company's common equity. Creative structures using varying cash and non-cash interest rates and equity ownership have become more commonplace with mezzanine sources. PIPES are such investments made by private investors into public companies. Private equity has historically engaged in PIPE transactions but to a lesser extent than venture capital and hedge funds. PIPE transactions are typically structured as a minority investment in a publicly listed company and the investor does not receive the full panoply of control rights and protections of an LBO. PIPE transactions offer the possibility of a healthy and quick return due to pricing discounts, near term liquidity options and creative structures.
An example of a mezzanine/PIPE deal: In November 2008, Whole Foods Market announced a sale of a 17 percent stake in the company to the private equity firm Leonard Green & Partners for $425 million. Under the terms of the deal, Leonard Green, through its affiliate Green Equity Investors V, acquired preferred stock that pays an 8 percent dividend and is convertible into common stock. The investment served as a buffer for Whole Foods, which wanted to maintain a strong balance sheet to navigate through the recession and meet its debt obligations from its 2007 Wild Oats acquisition.
Creative financing opens doors for PE in a difficult operating environment; retailers benefit from the liquidity and capital infusion necessary to survive the recession without relinquishing company control. Surprisingly, not many PE/retail deals have occurred in 2008-2009; greater valuation stability, better earnings visibility, sustained restriction of alternative sources of capital and increased awareness of creative structures available will likely lead to increased transaction flow.
Jennifer Herber is a Managing Director at Stephens Inc., where she covers specialty apparel and household & personal care retail investment banking. Stephens Inc. is a full-service investment banking firm headquartered in Little Rock, Arkansas, with offices across the country. For further information, contact Ms. Herber in the firm's New York office at 212-891-1745 or via e-mail at [email protected].
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