Closed for business?

In a year which has seen numerous write-offs and companies entering administration, the retail sector has been hit hard by the credit crunch and things are set to get worse. But for some private equity players, this could be the perfect time to grab a bargain.

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 its effect on consumers’ psyches, caught most of them unawares. Among other things, the shock has brought deal flow to a halt, while jeopardising some of the deals made at the peak of the market and increasing 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 surveying the damage wrought on valuations and trading outlooks for UK and European retailers.

The recent downgrades to economic growth made by economists and central banks are unlikely 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 stock market 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 is that consumers will curtail their spending due to the credit crunch. This comes on top of very cold spring weather, which caused a 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 accountants 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 some positive signs amid the gloom. In the UK like-for-like sales have held up surprisingly well – with the exception of the likes of Jessops and Next. And in Europe there are signs that the value end of the clothing market is holding up. In March, Sweden’s Hennes & Mauritz (H&M Group) 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.

On hold

These bright spots have been insufficient to dispel the gloom that hangs across the sector in the City of London. In the febrile climate there, investors latch on to any bit of bad news to drive share prices lower. When DSG — owner of technology retailers Currys and PC World — issued its second profits warning on 10 April, the shares were marked down a further 8%. However stockmarket gloominess has yet to be fully reflected in private market valuations — partly as few vendors have dared test the waters in recent months. While this backlog of deals remains on the shelf, private market valuations are holding up surprisingly well.

“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 Change Capital Partners. “A lot of deals are currently on hold, as many owners would rather just sweat it ou than risk selling at a time when markets are so weak and uncertain.”

Change Capital Partners has several retailers in its portfolio, including UK hardware group Robert Dyas and the Spanish electrical goods retailer Master Cadena. Given the current conditions, Vandevelde said CCP has no intention of exiting any of these in the foreseeable future.

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 be a spate of deals as desperate vendors seek to cut their losses and the bottom-fishers get out their metaphorical 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 NBGI private equity, believes that the new market dynamic has been ushered in by the credit crunch, and that this will work in favour of mid-market buy-out houses.

“It’s going to be an interesting couple of years,” says Morley. “I think there’s going to be plenty of distressed situations and opportunities for turnarounds, as well as lower multiples generally. We’re certainly watching with interest. It is definitely a bad time to be exiting a retail business, however.”

Richard Mathews, head of consumer and leisure at HgCapital, said: “Either the public market investor or the 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, a former chairman and chief executive of Marks & Spencer, 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 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.”

European hope

Vandevelde, who was chief executive of Marks & Spencer 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 place such as Ireland, 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 cloudy outlook for UK consumer spending, Continental Europe is going to present the most interesting opportunities in the near term.

He would not comment on the possibility that Galicia-based Inditex Group (owner of fashion chain Zara) might become a target for private equity, or peculation 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 2003-4.

Before that time many banks and investors were deterred by high levels of operational gearing in the sector: some had 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 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 buccaneering types such as Sir Philip Green and Sir Tom Hunter showed what could be achieved soon after the Millennium and also because of the period of economic stability that Gordon Brown ushered in as chancellor 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 that retailers can provide, and the way business models can readily be rolled out nationally and internationally.

Animal magnetism

According to Hg’s Richard Mathews, the sweet spot for private equity investment in retail 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, the banks rapidly rediscovered their scepticism about the retail sector — and many other sectors. 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.

However, 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.

This article was published in the May 2008 issue of EVCJ – the European Venture Capital & Private Equity Journal. To read the entire article it is necessary to subscribe to EVCJ.