After two years on the sidelines private equity money is back in retail. George MacDonald finds out why and what investors are looking for
After a three-year gap, private equity deals are once again in full swing in the retail sector.
Since the start of the year there has been a spate of deals. The action started with the jaw-dropping £955m sale of Pets at Home by private equity firm Bridgepoint to buyout giant KKR and has continued since, most recently with Warburg Pincus’s £200m acquisition of Poundland from Advent International.
What has sparked this surge - valuing some retailers at as much as 10 times’ earnings - and is the rate likely to be sustained throughout 2010?
As the credit crunch bit and recession gripped the UK, potential business buyers and would-be sellers put the idea on hold. Traumas such as the late 2008 collapse of Woolworths and MFI put the stores sector out of fashion on the back of fears of a big spending slowdown.
The surprise was that although the downturn continued to claim retail scalps the sector as a whole managed conditions well and the strongest businesses put in powerful performances.
Hard evidence of successful trading by retailers through one of the toughest recessions in history brought them once again onto the radar of private equity which, because of the deals drought, was looking for a home for investment funds left unspent.
But it has not been a matter of any deal will do - the defining characteristic of retailers that have been sold is that they are successful, niche players.
At the high-water mark of the takeover boom in 2007 it seemed as if almost any chain could prick the interest of buyers flush with cash and with a direct line to bankers delighted to stump up debt. But almost overnight, things changed as embattled banks pulled in their horns as the financial crisis hit.
The deals of this year do not mark a return of the gold rush days. One private equity source summarises market conditions succinctly. “It hasn’t reopened completely,” he says. “It has reopened for certain assets.”
Serial deal maker John Lovering, who worked with private equity firm Permira on its prospective purchase of DFS and played a prominent role in deals such as Debenhams and Homebase, makes a similar observation. “The scale and valuation of deals has been quite surprising,” he says. “The lesson is that well-positioned, niche retailers with growth prospects will find a buyer.”
Private equity groups, keen to put uninvested cash to work, bit when the bait of a good business was dangled before them. One corporate finance adviser says: “There’s a mountain of private equity money that needs to be spent. A lot of funds raised money before the crunch, then sensibly kept their hands in their pockets but are now under pressure to spend the money.”
Unused money is bad news for private equity firms. Lovering says: “In some cases they might have to return monies not invested [to the original contributors] and if you haven’t invested an old fund it can be difficult to raise a new one.”
One new aspect of the recent deals is that the proportion of equity versus debt has changed since the boom years. The amount of equity is now likely to be higher or in some cases, such as HobbyCraft, the transaction may be all equity.
“Using debt enabled you to rely on the magic of leverage to make some of your returns,” says one financier. “Now people need to rely on improving the business rather than financial mechanisms. Returns may not be as good but lack of leverage means you can afford an occasional like-for-like hiccup.”
However, it is likely, says one private equity source, that leverage will be introduced gradually into acquired companies as operational and financial advances are made under new ownership.
Size doesn’t matter
Another shift of the past few months has been that private equity funds, which traditionally would have pursued bigger deals, have been willing to chase companies that have in the main been part of what would have been called the “mid-sector”.
That is likely to remain the case because, although bank funding for deals is available, the sums that could once have been accessed look unattainable as countries scrape out of recession.
Del Huse, managing director of private equity firm Endless, says: “There is lending available but on a very measured and risk-averse basis. The big deals aren’t there - there won’t be anything like Boots again any time soon.”
But vendors of businesses are likely to have been pleased by the prices achieved, partly reflecting the competition between private equity funds for transactions. Huse says: “There’s a lot of appetite and only a few deals, which is reflected in the prices.”
Cath Kidston chairman Peter Higgins says the retailer’s decision to sell was taken because “it was the right time for the business” rather than specifically because private equity was becoming more interested in retail again but agrees only good businesses will get away. He says that investors are looking for “best in class” companies in order to de-risk.
The unique positioning of Cath Kidston and Poundland’s first mover advantage into single-price retail are both representative of the strengths investors are looking for, he says.
So will there be more sales to private equity as the year goes on? Uncertainty about consumer finances and a new government - which is likely to have prompted some business owners to sell ahead of potential tax rises - bring uncertainty but are unlikely to scupper the right deals.
Permira consumer sector partner Martin Clarke says: “There’s a sense the recovery, however feeble, is under way and this is not a bad time to be investing. There’s more debt becoming available.”
Lovering says he would not be surprised to see any business that meets the right performance, growth and proposition criteria, and has been in private equity hands for four or five years, to potentially be sold.
Simon Davies, corporate finance partner at Grant Thornton, which advised HobbyCraft’s owners on its sale, thinks there will be more deals. He says: “The banks are back on a proper footing and people are looking forward with a greater degree of confidence. Last year’s polarisation meant that those businesses that did well have become more valuable. Those that have been sold have gone at a good price, and that’s likely to be a catalyst.”
One fact is clear, says one private equity source: “The only businesses being sold are good businesses.”
The Key Criteria: Track record, differentiation, growth
All the retailers successfully sold this year have been undisputed recession-busters, gaining ground despite the harsh trading environment.
Financial success made them attractive to buyers willing to pay for their track record and confident it would continue. Value for money appeal and niche positioning have emerged as trends.
Pets at Home generated EBITDA of £70m last year (to March 31, 2009) on sales of £402.2m. In the 41 weeks to January 7, 2010, it generated like-for-like growth of 9.8%. It is the only specialist of its type with scale. KKR deal maker John Pfeffer said at the time of the acquisition that the retailer was “exceptional” and was enthusiastic about “the significant further potential for Pets at Home to grow”.
In a big-ticket market decimated during the downturn, DFS emerged as almost the last man standing in its category. Under the leadership of Lord Kirkham, DFS’s EBITDA soared 42% to £86.7m last year and he saw potential to take sales to £1bn.
Before the sale he insisted there is “loads” of growth left from opportunities such as more selling space, a wider product offer and higher average order value. Advent International director Andy Dawson said at the time of the deal: “We intend to evolve the existing business model in order to access more customers through new store roll out, online and brand development.”
Similarly TA Associates’ acquisition of a majority stake in distinctive home and fashion specialist Cath Kidston reflected that the retailer is “well positioned to capitalise on its unique branded products and design aesthetic to grow rapidly wordwide”, according to the private equity firm’s managing director Jeffrey Barber.
HobbyCraft, built from scratch into a 47-store chain, has established leadership in what remains a highly fragmented sector thought to be worth about £2bn a year. Bridgepoint’s investment in the retailer is expected to enable it to accelerate growth through, for instance, multichannel development as well as store openings, and to enable operational enhancements.
The recession meant single-price point specialist Poundland could exert increasingly powerful appeal to consumers and expects to generate sales of about £700m in 2011 in a value market estimated to be worth £24bn altogether. Warburg Pincus’s takeover of the retailer will result in speedier expansion. Poundland, which has 260 shops, intends to open another 50 this year and is considering launching overseas.
Other retailers that may be sold this year are likely to share the above characteristics. One potential sale candidate being talked about in the market is cycling etailer Wiggle. Backer Isis has dismissed speculation that the business is being prepared for sale any time soon - Halfords is talked of as a buyer - but the talk persists. One source said Wiggle would be “a big one for Isis” but thought the private equity firm is likely to hold onto the business for a while unless “offered a hell of a price”.