Analysis: Has private equity ownership done retail more harm than good?

Identify value, realise it through funding and expertise to accelerate business growth, sell on in the expectation of future success – that is the alternative version, welcomed with open arms by investors in the latest round of IPOs of retailers such as Dr Martens, Moonpig and The Hut Group (THG).

They follow in the footsteps of others including Pets at Home, previously invested in by Bridgepoint and KKR.

But is it really a case of one or the other when it comes to private equity ownership of retailers?

The term encompasses a range of investor types from distress purchasers such as Hilco, owner of Homebase and formerly HMV, to financial giants KKR and TDR Capital, through to specialists like Index Ventures, which provides venture capital to entrepreneurial companies.

It is even sometimes applied to individuals such as former Topshop tycoon Sir Philip Green, whose deals shared characteristics with private equity houses.

Debating debt

At the heart of concerns about private equity investment is often the issue of debt, a key component of acquisitions. 

Debt is deployed because it is efficient use of capital, reducing the amount of equity needed to be put up by the private equity house and so enabling a greater return on that equity. 

The private equity house risks less on its equity investment while the cost of debt, put forward by banks, is borne by the acquired company. 

While some level of debt is part and parcel of almost any private equity acquisition, the big potential downside is that any subsequent downturn in trading can break the business as it struggles to repay debt. 

As one financier observes, in the case of retail, debt can be particularly problematic. 

“Retail isn’t suitable for that sort of financing structure,” he believes.  

“Not only do you need to finance your bank loans; you need to pay the rent. You have two fixed costs – interest and rent – so that doesn’t give you much flexibility if there’s a slowdown in sales.”

“Private equity worked best in a growth market. You were often able to pay yourself back the money you’d paid for the company by selling assets. Today that private equity model doesn’t work any more”

Richard Hyman, retail adviser

Veteran retail adviser Richard Hyman echoes that view. “Private equity worked best in a growth market. You were often able to pay yourself back the money you’d paid for the company by selling assets. Today that private equity model doesn’t work any more.

“That doesn’t mean PE is over, but it needs a model that’s about trading, not rearranging the cost side of the business.”

Debenhams, for instance, infamously carried more than £1bn of debt and that burden is still blamed by some today – almost two decades after the deal – for the retailer’s eventual failure.

The recent acquisition of Asda is also worryingly reminiscent for some of the highly leveraged deals of the past – while Asda was valued at £6.8bn, private equity group TDR is only putting in £780m.

A further £4bn has been raised through loans (debt), while sales of assets including warehouses will generate almost £2bn.

Hyman says Asda’s new owners the Issa brothers “could go in and take money out, but ultimately the success of the deal will be about whether they trade the business better”.

“I think they can, but not by using traditional private equity initiatives around costs rather than revenue.”

Risk vs returns

While Asda’s highly leveraged buyout has justifiably garnered a lot of attention, private equity deals involving such a high level of debt are far less common than they were before the financial crash in 2008. 

Now, says one retailer who has been involved with a variety of businesses controlled by private equity, deals might involve debt of up to four times’ EBITDA – far closer to the two to three times’ ratio common in public companies and down from as much as six times before the crash.

In 2005, for instance, Debenhams’ net debt stood at 5.9 times its EBITDA, although that was down to 3.1 a year later. 

“The old model really disappeared after the financial crisis,” he says. “Modern private equity generally wouldn’t go anywhere near the sort of leverage that was put in before.”

Former Tesco chief executive Sir Terry Leahy is now a senior adviser to private equity group CD&R and chaired value giant B&M, acquired by CD&R in 2012 in a deal reportedly worth £965m. B&M generated about £1.5bn for CD&R following its IPO in 2014.

Leahy observes that PE firms bring to their investments equity and debt, which is spent on building the business as well as sometimes on dividends.

He says: “Debt in itself isn’t a bad thing. Private equity has long-standing banking relationships that enable it to raise debt that the businesses might otherwise struggle to raise.” 

“If a business does well, the extra leverage can produce a good return for all investors. If it doesn’t do so well, the business can get into trouble. The failures have to be seen in the context of overall more successful investment and job creation for growth”

Sir Terry Leahy, former Tesco chief executive

He acknowledges that the private equity model may bring risks, but says: “Judgement has to be carefully applied. If a business does well, the extra leverage can produce a good return for all investors.

“If it doesn’t do so well, the business can get into trouble. The failures have to be seen in the context of overall more successful investment and job creation for growth.”

Although there have been some great successes, private equity can go wrong, too. Private equity owners have sometimes misread business potential at the time of acquisition – in particular, failing to realise the speed at which the retail environment was changing.

Poundworld, for instance, collapsed in 2018 three years after its acquisition by TPG. Changing consumer habits were blamed, but founder Chris Edwards claimed the retailer had been “very badly managed”.

He said the new management failed to understand Poundworld’s customers and business model. Other recent collapses under private equity control have included Maplin and Toys R Us.

The objective of private equity is to generate greater returns than would be achievable through other forms of investment, such as the stock market. Rather than achieving it through asset stripping, it is about business building, supporters argue.

Leahy says: “If they acquire a business, they must believe they can do something with it and they can be a very good partner to management or bring in talent.”

Lacing up to go faster

Footwear specialist Dr Martens has just floated, valued at £3.7bn. The IPO generated £1.29bn for private equity owner Permira and other shareholders. Permira bought the business for £300m in 2014.

Dr Martens chair Paul Mason, a former Asda boss who has since worked with private equity in several businesses ranging from Somerfield to Cath Kidston, says that the business has been transformed since its acquisition from the Griggs family – also beneficiaries from the IPO.

He says that when the deal was done Dr Martens “had a manufacturing mindset”, but Permira saw the chance to create value and build the business by shifting emphasis.

“What private equity does very well is targeting underinvested or under-professionalised businesses. It’s not about buying cheap. It’s fast and efficient, and it’s fast because the owner is sitting at the boardroom table” 

Paul Mason, Dr Martens

He says: “Their footprint was all about finding wholesale partners, but we saw a huge brand in a medium-sized business and developed the D2C model.

“That allowed us to slim down the wholesale footprint. We were looking for beacon stores in key locations and great partners in bricks-and-mortar or digital.”

In the period of Permira’s control, Dr Martens’ sales rose more than threefold from £209m to £672m, and online grew from 7% of sales to 20%. 

The business was steered by chief executive Kenny Wilson, who had run Cath Kidston alongside Mason when it was owned by private equity group TA. 

Mason says: “What private equity does very well is targeting underinvested or under-professionalised businesses. It’s not about buying cheap. It’s fast and efficient, and it’s fast because the owner is sitting at the boardroom table.” 

That seat at the table, and the funding that comes with it, opens up new avenues to acquired companies or enables them to speed up plans.

In the case of Moonpig, for instance, acquired by private equity house Exponent in 2016, it helped the online greetings card specialist make the most of early mover advantage, observes HSBC head of retail James Sawley. The retailer has just floated, valued at £1.2bn.

Similarly, THG was the biggest IPO in five years when it listed on the London Stock Exchange. KKR, which had been a minority investor for six years, turned an original investment of £100m into £448m.

THG is one instance of private equity investors working well alongside founders. Another would be Gymshark’s Ben Francis.

In a YouTube video following General Atlantic’s acquisition of a 21% stake, valuing the business at £1bn, Francis, who increased his shareholding, said: “It would be remiss of me not to bring in the right people to elevate us to the next level. We saw a lot of companies.

“The first time we met [General Atlantic] they got the brand culturally; they were dead-on. They will truly help us grow.”

Sawley says private equity plays a helpful part in such situations. “The founder has put their heart and soul into it. It’s sensible to take a bit off the table and you need equity from somewhere,” he says.

Retail reservations

With a track record of stellar success and dismal failure, private equity firms are still doing deals. TDR and the Issa brothers won Asda, but the grocer was also in the sights of Lone Star and Apollo.

This month, Carlyle bought into fashion retailer End, valuing it at £750m and highlighting its omnichannel credentials. 

Some believe the Asda deal, with its high level of debt, is more akin to the deals of old, while the End acquisition is emblematic of the changing face of a retail industry increasingly reliant on digital opportunity to drive growth.

However, Leahy cautions: “I think retail is quite difficult to invest in at the moment because of the extent of disruption by ecommerce and digital transformation. It’s not straightforward.”

Mason says: “Now it is increasingly about leveraging the internet. The whole dramatic channel transformation – a lot of people just didn’t see it. It would be difficult to buy into retail today without a clear digital strategy.”

“Although people think private equity is short-term, they have to think reasonably long-term or they can’t sell. Reputationally, it matters that investors continue to thrive after [private equity] ownership” 

Sir Terry Leahy, former Tesco chief executive

For private equity-backed businesses, success will be ultimately measured by the returns for investors and whether they are still thriving when ownership ultimately changes.

“If you want to sell, the business needs to be in a good shape,” notes Sawley. 

Leahy says: “The business has to be attractive to a new owner, so there has to be value and quality left in it. Although people think private equity is short-term, they have to think reasonably long-term or they can’t sell.

“Reputationally, it matters that investors continue to thrive after [private equity] ownership.” 

So, while private equity houses may typically own a business for three to five years – although it may be longer – the businesses should in theory be set up for longer-term success.

Private equity ownership may sometimes leads to turmoil and failure, but it frequently leads to success and reward – not just for one owner for a few years, but for others in the future.