Toys R Us store
The accepted wisdom is that the private equity business has played a significant role in the destruction of the retail industry. A much publicized recent study by the Center for Popular Democracy and other groups claims that almost 600,000 jobs have been destroyed in retail in the last 10 years by private equity-owned retailers. Together with jobs lost at related suppliers and other businesses, the report claims that almost 1.3 million jobs have been lost in retail as a result of private equity investments. Even my fellow Forbes contributors have agreed.
I don't see it that way. Private equity groups are an easy target but not the right place to lay the blame for the tectonic retail changes that have had so many negative effects on stores. While the number of retail jobs lost in the report may be correct, the allocation of blame to private equity is a form of scapegoating. There are many causes of the changes in retail and private equity has a role, but placing blame at the doorstep of the private equity industry is just not correct.
Let’s understand what private equity does. Most of the time, private equity uses a relatively small amount of equity and a lot of debt to buy companies. In order for those deals to succeed for the investors, the companies being bought need to be stable or growing to repay the debt and pay dividends to the investors or be sold for a higher price at a later time. An experienced private equity investor looks at hundreds of deals, often thousands, before choosing one to invest in. Private equity investors make money by having the companies they invest in do well. They do everything they can to avoid having the companies they invest in default on their debt or go bankrupt.
The point at which a company bought by private equity is at the highest risk of failure is usually in the first two years after an acquisition. That’s when the debt level is usually highest. If the company experiences a downturn or a serious bump during that period, there’s a good chance it won’t be able to meet its debt obligations and find itself in serious jeopardy. Once the first two years pass, there’s a little more financial elbow room and an acquired company is better able to withstand a bump or downturn.
If a company with a good business runs into trouble at a time when it has high debt, it has options. One of those options is to raise more equity capital to sustain itself, either from its existing investors or new investors. That dilutes the private equity owners but it’s better than going bankrupt and losing the entire investment.
In 1998, Toys R Us was the largest retailer of toys in the US. In 1999, Walmart passed it by and has increased its lead steadily ever since. At the time of Toys R Us’ bankruptcy, Walmart sold almost 70% more toys (in dollar volume) than Toys R Us and Target is close behind. Online, Amazon is the champion in toy sales, far surpassing Toys R Us online sales.
In the midst of Toys R Us' decline in market share, the company was purchased by private equity investors. No doubt the investors made the wrong judgment that they could reverse Toys R Us’ market share decline. If Toys R Us had a great future when it went bankrupt, it could have emerged with a new owner and new capital to continue. The debt would have been wiped out by the bankruptcy and it could have started all over again. So you have to ask, why didn’t that happen? After the private equity investors failed, why didn’t an investor scoop it up once the debt had been put in abeyance by bankruptcy? Why didn't the debtholders themselves take it over and build it with additional investment, why did Toys R Us have to liquidate? What’s even more curious is that all the other examples of private equity-owned retailers in the report who went bankrupt have likewise vanished. If Toys R Us, Payless Shoe and RadioShack were such great businesses, destroyed only by the greed and avarice of private equity, why did they disappear instead of being scooped up by other investors who could have made them into unleveraged, great businesses?
The answer is more complex than the current wisdom would have you believe. Retail is going through a transformation. Changes in culture and technology have caused historically successful retailers to experience lower foot traffic, lower sales and lower profits. It’s not just highly-leveraged retailers that are suffering. It’s hard to name any major legacy retailer that has successfully adapted to the changes.
What is true about private equity-owned retailers is that they have less time to adapt to change than other companies because of their high debt levels. If they can’t figure out a solution quickly, they wind up in default and often in bankruptcy. What the accepted thinking doesn’t address is why those bankrupt companies don’t restart after their debt is put on hold in a bankruptcy.
The changes in retail are bigger than the popular thinking would have you believe. The world can no longer support as many retailers selling me-too products as in the past. The companies with debt are at the head of the line to experience upheaval and that’s why they go bankrupt first. The changes in retail are a long way from done and by the time it’s over, we’ll see many other legacy retailers go bankrupt and vanish.
In the recent past, Neiman-Marcus put itself up for sale and found no buyers. Nordstrom tried to raise capital to buy out the public shareholders and failed to find a taker. Barneys is on the market, no buyer has emerged yet and if one does, it will no doubt emerge from bankruptcy a very different, smaller company or it may disappear. JC Penney is often discussed as the next candidate for bankruptcy and no one has appeared yet who wants to buy or merge with it. It’s certainly more risky to be owned by private equity. But it’s wrong to say that private equity is responsible for the demise of so many retailers. Every retailer is experiencing change and very few are adapting. Investors are running away from legacy retail opportunities and that makes capital scarce at a difficult time. Private equity is able to buy these risky companies at attractive values because no one else wants them. If the risky companies go bankrupt after being bought by private equity, maybe there’s some blame to be allocated to the investors and the debt, but that’s hardly the driver of all the negative changes.
Wall Street is a cutthroat place and private equity is no exception. Private equity investors are often rich, Ivy-educated and based in New York or Los Angeles. Their business is an unemotional, rational process. All of that makes them seem heartless and easy to dislike and demonize.
I deal with private equity investors in my mergers and acquisitions work almost every day. What’s great about doing deals with them is that it’s never personal, it’s strictly about the deal and how they can maximize value; I like dealing with them, there's no pretense and they are very straightforward and smart. I get why people don’t like them but it’s not correct to say that they’re the bad guy in the closing of all these stores.
For more on this topic, the podcast below is a discussion I had with Kristin Carpenter of Verde in which she and I discuss the relationship between private equity and retail as well as other other related changes in the retail industry.
