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PRIVATE EQUITY STILL PURSUING ‘UNDERVALUED’ RETAIL BUYS

By Curt Hazlett

For ShopKo Stores, there were good times. The retailer went public in 1991 after opening its 100th outlet. Eventually, it built its sales to $3 billion. But ShopKo ran into trouble competing with Wal-Mart and other big boxes. Its stock price seesawed from $10 to nearly $40 to $4 before climbing back into the teens last year.

In April history came full circle. Goldner Hawn Johnson & Morrison, a Minneapolis private equity fund, offered first $24 a share and then $25.50 to take ShopKo private. Goldner Hawn’s offer was topped by a bid of $26.50 from a group led by Sun Capital Partners. The group also included Klaff Realty, Lubert-Adler Partners and Developers Diversified Realty Corp. On Oct. 18 ShopKo agreed to a Sun Capital offer of $29 per share.

ShopKo is far from unique in the attraction it holds for buyout funds. Luxury retailer Neiman Marcus,Toys ‘R’ Us and Mervyns have all gone private in the past year.

“There’s a significant amount of money out there looking to be put to work, and retail has been a very attractive and successful investment for people,” said William Susman, president of Financo, a New York City investment bank specializing in retail. Indeed, Susman estimates that 40 percent of the retail mergers and acquisitions completed this year have involved private funding.

Why the keen interest in retail? In most cases the investors see undervalued assets, among them poorly used real estate and brands that are ripe for extension. ShopKo’s real estate, for instance, is valued at between $700 million and $800 million, virtually the full amount of the high bid.

Investors also like the relative stability a solid retailer can offer, and they have plenty of money in need of decent returns. “Private equity firms have been buying retailers for years, but with their deeper pockets, now their reach is even bigger,” said Fred E. Wainwright, executive director of the Center for Private Equity and Entrepreneurship at Dartmouth University’s Tuck School of Business.

Among the attractions of retail, Wainwright says, are “well-understood models and a steady cash flow. Although one could predict that consumer spending might go down, there are opportunities within the retail sector for successful companies to leverage their assets even more.” That might mean new uses for real estate or a more aggressive use of a retailer’s brand. “The private equity guys are so very good at finding inefficiencies and finding hidden assets,” he said.

From the retailers’ perspective, there are plenty of good reasons to listen seriously when private equity comes calling. Living with Wall Street’s valuations is always tough, but the impact on a retailer’s stock price of a big slowdown in consumer spending is especially unnerving. Given the expectations out there for slower spending and higher interest rates, this might seem like a particularly good time to sell.

Being publicly traded is a special problem for retailers with a mature concept, says Rajiv Lal, a professor of retailing at Harvard Business School. “When a retail concept takes off, it has expectations of growth, and when you have those expectations built into your stock price, you need to deliver,” Lal said. “But every concept matures. When it is unable to deliver on the growth built into the stock price, things become difficult.

To a large degree, private equity “is replacing what the stock market used to do,” said Richard Hastings, senior vice president and retail sector analyst at Bernard Sands, a New York City-based retail market advisory firm. “The stock market and the regulatory environment sometimes make it hard to be a public company. And if you’re not going to use the stock market as a tool to raise money, then what’s the point of being public? Private equity is able to provide an excellent alternative in helping companies raise money.”

Adding to the pressure to go private is the Sarbanes-Oxley Act of 2002, the disclosure law that puts chief executives personally on the hook for any financial irregularities at their companies. Vermont Teddy Bear Co., an online retailer that sold $66 million worth of teddy bears, pajamas, flowers and food last year, was taken private by Mustang Group in September, largely because of this law. The company said the cost of compliance topped $300,000 last year, an amount it said was likely to double in coming years.

But going private is not always a retail executive’s fondest dream. “It’s not a respite from pressure,” said Elizabeth S. Obloy, managing director of national retail at Studley, a New York City-based commercial real estate brokerage firm. “I worked at Coach when it was private and when it was public, and you’re still under the same demands. There are high goals for management.” Still, she said, “if you’re a public company, you have to grow faster, because you’re always putting expectations out. Sometimes you grow faster than you’re able to handle internally.”

One upside to private ownership is that the investors can provide the capital for greatly needed improvements. But turnaround efforts can bring pain, too, and for retailers acquired by equity funds there is likely to be plenty of it. “These guys can be pretty ruthless in the way they do business,” said Wainwright. “That means smaller staffs and tighter controls on expenses.”

One area not altered much under private owners is the relationship between retailer and landlord. “To the extent that management changes, there may be some change,” said Obloy. “But for the most part, these private equity investors are silent owners.”

Financo’s Susman puts it this way: “As long as the landlord gets a check once a month, he doesn’t care.”

Even so, the wave of buyouts could have an impact on retail real estate. Analysts say many of the deals, ShopKo’s included, will probably be financed through the sale of real estate, raising the possibility of a glut.

Perhaps the biggest questions raised by the private equity frenzy are: Where is this headed? And will there be a wave of IPOs among retooled retailers in a few years? “Some of them do go back and do an IPO,” said Harvard’s Lal. “But if the retailer continues to spew out a lot of cash, people hold it.”