Leveraged buyouts, or LBOs, may be out of style in the retail sector, but seasoned investors watching the changing industry could find opportunities if they’re willing to adjust their timeline for returns.
Generalists will probably steer clear of retail right now because the sector is littered with broken business models and irrelevant brands.
“The risk/reward spectrum through which private equity would look is not good,” said Tom Bonney, senior managing director of CBIZ CMF, the private equity advisory practice for national professional services provider CBIZ. “Groups that used to be general investors have stopped investing in retail and now it’s just specialists investing.”
The Toys ‘R’ Us liquidation is one more symptom of a retail sector that is undergoing a massive shift to digital. It’s a sector that has too many stores and is weighed down by the debt that came with a number of LBOs.
Read: Toys ‘R’ Us is still facing major challenges in the liquidation process
Also: Retail defaults may increase in 2018 as companies are still stressed, S&P cautions
With this as the backdrop, Bonney said “subject matter experts,” those knowledgeable in areas like digital marketing, real estate and loyalty programs, or industry executives in areas like beauty, off-price retail, which includes companies like TJX Cos. TJX, -1.23% and Ross Stores Inc. ROST, -2.83% , and home goods are investing in the sector.
Bonney thinks this is a positive because it puts assets in the hands of people who are “A-players.”
Though it may seem that there’s a retail apocalypse underway, the broad conditions for the sector are actually pretty good. Consumer confidence is near an 18-year high, employment numbers are strong and the tax overhaul is giving the economy a boost, even if rising interest rates and a fluctuating stock market have dampened some spirits.
See: Consumer confidence retreats in March but still near 18-year high
The SPDR S&P Retail ETF XRT, -2.64% is up 3.7% for the past year. The S&P 500 index SPX, -2.23% is up 9.5% for the last three months, while the Dow Jones Industrial Average DJIA, -1.90% has rallied 14.5% for the period.
“While some sub-segments of U.S. retail will improve in 2018 — even including department stores — weaker issuers will continue to struggle,” wrote Moody’s analysts in a March 14 note, forecasting defaults from at least six retail and apparel companies over the next year. Moody’s says high leverage “challenged operating performance.” What’s more, there will be a “jump” in the amount of retail debt that matures in 2019, the ratings agency said.
“Many of the names on our distressed list and those that have been filing for bankruptcy are sponsor-owned legacy LBOs,” the note said. Among the names on the list are Nine West Holdings Inc. and David’s Bridal Inc.
“As the larger, better capitalized retailers continue to grow and prosper, the smaller, highly-leveraged retailers are struggling harder to compete and survive,” Moody’s wrote. There four areas that highly-leveraged companies could have problems with: capital structure, liquidity, capital spending and investment as well as competitive positioning.
Given the situation, Larry Perkins, founding partner at SierraConstellation Partners, a financial advisory and turnaround firm, says there’s a timeline “misalignment” between retail and the buyout strategy.
“The returns they’re looking for is to double their money in three to five years,” he said.
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The companies that “warrant capital” are those that can “expand without large fixed capital investment, like a lease” Perkins said. Retailers that operate primarily online, or have a system that uses more warehouse space than traditional store space, like Nordstrom Inc.’s JWN, -1.82% Trunk Club or Bonobos, which was acquired by Walmart Inc. WMT, -3.84% last year.
And, of course, the elephant in the fitting room is Amazon.com Inc. AMZN, -5.21% , which has added hundreds of locations through its Whole Foods Market acquisition, but otherwise only has a handful of bookstores and an Amazon Go location.
It should be no surprise that the retail investment story, at this point, comes back to the digital disruption that many companies are experiencing.
At one point, retailers Sears Holdings Corp. SHLD, -3.00% , Walmart and Target Corp. TGT, -0.65% changed catalogue or store shopping, but as Simeon Hyman, head of investment strategies at ProShares, said, nothing stays new forever. Proshares offers ETFs with more than $30 billion in assets.
“In retail there used to be a rule of thumb: a new concept has a 20- to 30-year life cycle then it’s disrupted,” Hyman said.
Even grocery, which seemed like it could never be touched by the internet, is heading online.
“Technology moves so quickly, when you think something is immune, it might not be so immune after all,” said Hyman.