It is often thought that any private equity firm could invest in a retail company. Some investors have this mindset because they encounter retail brands every day and the sector is seemingly easier to understand than others, such as tech or energy. However, investments in retail companies that aren’t nurtured properly can have catastrophic results. To be successful, retail companies need strong, flexible capitalization and investors who employ a disciplined approach. To gain insights into the ins and outs of investing in the retail sector, Mergers & Acquisitions convened a special discussion that included two private equity professionals and an investment banker. Here’s what the professionals had to say.
Kevin Nickelberry, Managing Director, Investcorp: The retail environment has changed over the past few years. The competitive intensity has increased for both investors and retailers. Today, consumers are more informed and have more ways to buy products than ever before. The challenge for retailers is to become a destination for customers, wherever they shop, and to develop ways to increase customer engagement and interaction in-store and online. Investors must be prepared to provide additional resources and support management as they navigate this new competitive landscape.
Benjamin Geiger, General Partner, Freeman Spogli: In today’s market/landscape, one of the most significant challenges is the competitive deal environment. The market is bifurcated; there are premium assets and there is everything else. Valuations for the best businesses, those that performed well during the downturn, are robust. There is also competition for these assets from the public market. However, private equity can and should be one of the primary investors for quality consumer companies. These businesses require capital for growth and private equity understands how to efficiently allocate and prioritize growth capital. Private equity also understands how to help companies manage their growth. Hyper growth can happen with unique retail companies, but it has to be well managed. This is why investing behind the very best management teams and being an actively engaged investor is critical.
The second challenge is protecting the brand and customer experience. Investors have to find the right brand or retail format, and it has to have staying power. The brand has to resonate over time. It can’t be hip and trendy today, but get stale tomorrow. Lastly, the most successful brands have a business model that has been proven across different economic cycles.
Andrew Martin, Managing Director, Robert W. Baird & Co.: When you think about retail investments, there are so many different factors that will determine success or failure. You have to constantly think about changing fashion trends and consumer preferences, and how to be effective with consumers in an increasingly omni-channel landscape, with effective interaction in third-party stores, online and in your own retail locations. Additionally, there is enormous competition in today’s marketplace both for the investor seeking sustainable brands or concepts, and for those concepts in gaining the attention of a very educated consumer. Successful investors in retail companies often benefit from past experience in the sector. Deal structure is very important, as excessive leverage on expanding retail businesses starve companies of capital that is critical in funding growth initiatives. Considering the valuations necessary to successfully acquire some of these brands and businesses, substantial discipline is required to properly provide the investment with a capital structure that will allow for a future return while also giving the management team sufficient resources to invest in new stores, expand online capabilities, new personnel hires, etc. There also seems to be a dearth of strong management teams in the industry, thus putting an enormous amount of importance on identifying talent and retaining the right personnel.
Fugazy: Why are some firms more successful at investing in retail than others?
Martin: Successful investors are disciplined investors.You are seeing retail assets trading as high as 12 to 15 times trailing EBITDA. The best brands are achieving valuations that are significantly higher than what we witnessed prior to the recession. As such, buyers are tempted to use leverage in order to bolster returns and justify higher valuations. We have found that the most successful investors have a strong thesis around the pursuit of a certain brand or business and then develop a valuation that is consistent with that thesis. Those that have entered the sector with less discipline or a “win at all costs” mentality have not tended to fare as well. There is no substitute for knowledge and experience. Good investors have a strong understanding of a brand or concept’s future potential. Firms need to be able to answer with conviction questions such as: How many units can the concept support in its core and future markets and where specifically can and should you place them? How sustainable and loyal are the target consumers? What are the likely fashion or trend risks versus less cyclical or fickle models? Increasingly, investors enter processes armed with detailed market studies, consumer surveys and other analyses. Generally, we find that those who take the time and spend the money to conduct thorough diligence, while also having the comfort of having worked in the retail sector for years, often experience the best outcomes.
Nickelberry: The more successful firms stay true to their investment criteria and look for situations that allow them to capitalize on their experience and capabilities. This requires a disciplined investment approach and a commitment to developing skills that can add value to portfolio companies. Experienced investors also recognize the need to develop new and creative growth strategies and to provide management with the resources they need to execute their strategic plan. In a dynamic industry like retail, investors must be prepared to take advantage of emerging and unexpected opportunities to drive outsized returns.
Geiger: The more successful investors are seasoned in measuring risk, allocating capital, setting priorities and determining how fast to grow. Expertise really matters, which includes seeing what works and doesn’t work across business cycles. As investors, we get paid to pick which retailers are best positioned to become category killers. The better investors are patient. In a retail company, building value post acquisition takes time. You don’t just sign up a big new customer and grow overnight. You have to know when to play offense and when to play defense. The more successful firms also know not to over-lever because consumer businesses need liquidity and financial flexibility to grow. Just because you can get 5 or 6 times leverage, doesn’t mean you should take it.
Fugazy: What do the successful private equity firms do to drive growth at the portfolio level?
Geiger: You have to actively work to drive alpha. To do that we invest in systems, supply chain infrastructure and people in the earlier years. You need to have a strong foundation for growth. Investments could depress EBITDA in years one and two, but set the business up to be a growth enterprise for the long term. We use a 100-day plan and prioritize where to invest, whether it’s to augment an already strong management team, invest in IT tools, marketing programs or add-on acquisitions. We do this to maximize the potential in years four through six. It pays to be aggressive early on. We believe investors need to be prepared to provide additional financial support for growth and also in tough times to short circuit the run on the bank.
Martin: The best thing investors can do is provide portfolio companies with a capital structure that gives them the flexibility to grow. Retail businesses can deploy a substantial amount of capital if they are growing across various channels and if they are seeking to engage consumers across multiple points of purchase and media outlets. Additionally, we have found that private equity can also provide a healthy dose of adult supervision to family businesses or entrepreneurs, particularly in areas such as having an optimal capital structure, the prioritization of growth initiatives and the evaluation and timing of capital expenditures and investments, etc. Private equity investors have the experience from past successes and failures and can act as strong mentors to management teams who have previously relied on their own ideas. All private equity firms are not created equal in regards to the resources they bring to portfolio companies, but we have definitely found that they are often a highly valued resource to growing brands and concepts.
Nickelberry: Successful private equity firms use their structural advantages and build internal capabilities to support their portfolio companies. At Investcorp, we leverage our scale, global presence and experience in the sector to accelerate the growth of our portfolio companies. Our investments are completed on a dealby- deal basis, which allows us to take a longer-term and tailored approach to growing our portfolio companies. Essentially, our structure provides us the flexibility to invest in strategies that are in the best interests of the company’s long-term growth.
Fugazy: What are the key characteristics of your successful investments in the retail / consumer industry? How does that apply to the joint investment Investcorp and Freeman Spogli recently made in totes»Isotoner?
Nickelberry: If you look at the common characteristics of our most successful investments, you’ll recognize that they are all well-established brands and leaders in their space. These companies are highly regarded in their sectors and are committed to offering a differentiated shopping experience to their customers. We worked with the management teams to identify ways to grow the business, whether it’s through unit growth, international expansion or e-commerce. Great management teams are a key element in our successful investments and one of the most important factors we consider in our evaluation of any new opportunity. We see numerous opportunities to grow totes Isotoner and we are excited and fortunate to work with Doug Gernert, who has been CEO of the company for nearly 20 years. The company offers exceptional products and has a highly recognized brand. While they’re already a global leader, we think that the company has a tremendous opportunity to grow through further international expansion, as well as continuing to innovate and offer the high-quality products consumers expect from totes»Isotoner.
Geiger: We invest in businesses that have the potential to become best-in-class companies. We like consumer concepts that have a narrow focus and address a unique customer need while offering a multi-channel consumer experience. Totes has an integrated model with marquee brands that it sells through any channel where a customer may want to shop for the product.
You also need to maintain a differentiated store environment to fend off the intrusion from Amazon which requires strong management. We would rather invest in an A management team in a B sector than an A sector with a B management team. We are very excited about the growth potential for totes. Combining Freeman Spogli and Investcorp’s capabilities is powerful. We both have a lot of experience in the consumer retail space and we are backing an exceptional management team. The company is a market leader and is diversified across its customer base, so there’s no meaningful customer concentration. It’s also a highly regarded brand with low price points where the products are functional and not fashion driven. It’s been a leader for decades and developed a very defensible position.
Fugazy: Retail companies are strongly tied to macroeconomic conditions. How do you factor that into your investment strategy, value creation initiatives and even your conversations with limited partners?
Martin: There’s an interesting dynamic occurring in today’s market. For instance in apparel, going into the downturn and immediately thereafter, investors and consumers seemed most focused on the premium performance brands such as lululemon, Moncler and more recently Canada Goose. High price points, aspirational brands and elaborate technical features were viewed as differentiated characteristics and drove very strong results in both the public and private marketplace. These brands communicate with their pricing and take a hard line on both breadth of distribution and maintaining listed, as opposed to discounted, prices. Even with the global economy fairly stagnant, there is still an enormous number of companies and brands playing at the highest level. However, we are now seeing a recognition that today’s most influential consumers, those aged 25 to 40, are more educated and cognizant of value for money. We are seeing brands such as Athleta and prAna, which have price points that are slightly more approachable, experience substantial success with differentiated and functional products, multi-channel distribution models and strong connections with loyal consumers. As we continue to see flat levels of employment and discretionary income for younger consumers, we would expect brands that can inspire consumers on factors other than price to succeed.
Geiger: It’s hard to predict the exact timing of market cycles. Instead, we focus on investing in solid platforms that should do well regardless of the environment. We utilize an appropriate capital structure to allow for growth and to weather the storm in a down market. We like more discretionary categories and avoid high fashion businesses. Fashion can do well, but there is more beta to be sure. Our Limited Partners are looking for less volatility and stable, top-quartile internal rates of return across economic cycles and that’s what we aim to deliver.
Nickelberry: While we always consider macroeconomic conditions and industry dynamics when we evaluate investment opportunities, we generally invest in companies that participate in stable markets with a strong customer base and limited cyclicality. We look for businesses that have an established platform and are positioned to take market share regardless of economic conditions. One of the benefits of our deal-by-deal model is that it allows us to be patient. We are prepared to support our companies during difficult economic periods and give them the time they need to reach their full potential.
Fugazy: How does the role of e-commerce impact private equity investment in the retail industry?
Nickelberry: Investors have to be mindful of the impact e-commerce will likely have on the sector. Retailers must leverage their ability to provide a compelling, multi-channel shopping experience to protect market share. The online channel also has created a variety of growth opportunities for retailers and provides a new way of informing, instructing and engaging customers. Our goal is to fully participate in the growth online and to arm our portfolio companies with the resources to take advantage of this dynamic period in the sector.
Geiger: E-commerce is having the greatest impact on retail probably since the creation of the suburban mall. It creates a new level of transparency and it’s forcing retailers to be more consumer-centric. That said, “e-commerce” is transitioning to mobile commerce. On-the-go purchasing is what people are doing now. The more tech-savvy customers are moving into their prime spending years and they research online before purchasing. If a retailer does not have the right online presence, you won’t see that customer in your store. Retailers need to be omni-channel and offer customers the education they need to make an informed purchase. Customers are expecting retailers to communicate with them on a one-on-one level today. Personalized marketing is the next frontier. Consumer retail is an exciting and dynamic space to be investing in. Just don’t tell anyone else.
Martin: With almost any retail concept, there has to be a strategy around omni-channel distribution. You need to be able to communicate directly to the consumer, whether that be online, in your own stores or via mailed catalog. It is interesting that many thought the catalog business was dead, but what we are finding is that it drives more sales online and allows for a highly effective communication of a brand’s message. You can target specific groups of customers and utilize the feedback and spending patterns for any number of business decisions, such as where to build stores and how to merchandise by store or by region. In recent projects for Filson and Allen Edmonds, we have seen teams have enormous success expanding their consumer base by utilizing catalog, e-commerce and stores to directly engage consumers.