The list of retailers that have been bought and wrecked by private equity firms keeps on growing. This week, the beloved New York grocery chain Fairway filed for its second bankruptcy in less than four years and announced plans to sell off its stores, thanks to a disastrous run of mismanagement by a series of buyout shops. It’s on a list of casualties that now includes Toys R Us, Payless ShoeSource, and Sports Authority, among many others. That’s on top of financially troubled names like Neiman Marcus that have managed to avoid Chapter 11 or liquidation (so far).
Last year, a group of progressive nonprofits reported that of the 14 largest retail bankruptcies since 2012, 10 had involved companies owned by private equity. The thud of corporate failures has become so constant that it’s essentially become a meme in the financial press. “Have we finally reached the point where we automatically assume that every new retail disaster has been caused by a private equity firm?” Bloomberg’s Joe Nocera wrote after the Fairway news broke. “Yes, I believe we have.”
Why, exactly, have private equity’s adventures in the retail business created such a string of disasters? There’s probably no single answer, but here are three theories.
Theory 1: Sometimes, private equity firms really are just looters.
Private equity investors have a reputation for being corporate looters that buy and pillage businesses for profit before moving on to raid the next unsuspecting office park. Sometimes, it’s undeserved. But often, it’s entirely earned.
In theory, private equity firms exist to snap up underperforming companies, revamp their operations, and then flip them for a return. They’re often criticized for laying off workers and even cutting pay in the name of improving efficiency. But the much bigger problem is that they sometimes cripple previously functioning businesses by loading them up with unsustainable amounts of debt. They do this in a few ways.
First, the industry revolves around deals known as leveraged buyouts, where investors put up a small amount of their own money to purchase a company and borrow the rest. The business being acquired then becomes responsible for paying the debt, which increases its risk of going bust. Private equity shops are also notorious for extracting cash using “dividend recapitalizations,” a charming tactic in which they force companies to borrow even more money and use it to pay investors. Beyond that, they often charge the businesses they own millions in management fees.
Thanks to all of these tactics, private equity can often make money off a company even if its business fails. Take the case of Shopko, a Wisconsin-based chain that operated hundreds of discount grocers and convenience stores. In 2005, Sun Capital purchased it in a $1.1 billion leveraged buyout. It proceeded to sell off the company’s real estate, forcing it to rent its own storefronts, while vacuuming out $180 million of dividends and charging a heap of management fees. Shopko filed for bankruptcy last year and was liquidated, while Sun turned a profit.
Not all private equity deals result in companies getting strip-mined this way. They don’t even necessarily result in downsizing. Sometimes, firms just dial up investment in the businesses they acquire and try to expand them. Recent research has shown, for instance, that consumer product companies that get bought out tend to increase their sales by jumping into new product lines and markets. One major paper from late last year, “The Economic Effects of Private Equity Buyouts,” found that being acquired by a private equity firm actually boosted hiring at companies that were already private. Older work has found that industries with a lot of private equity activity tend to grow faster than others, possibly because businesses just become more efficient and productive.
And there are happy endings. In 2007, the private equity firm KKR and Goldman Sachs bought Dollar General. The company thrived, and KKR and Goldman made a mint a few years later after taking it public. Today, Dollar General is one of the country’s fastest-growing retailers; it’s planning to open 1,000 stores this year alone.
But there are a fair number of tragedies, too. Economists debate how often private equity deals actually end with businesses filing for bankruptcy, but one recent paper looking at public companies taken private pegged it at 20 percent, compared with just 2 percent for similar businesses that weren’t targeted for buyouts. Sometimes, even well-intentioned deals devolve into the high-finance version of shoplifting. When Sterling Investment Partners bought out Fairway in 2007, it intended to turn the local, family-owned chain into a national brand. But it badly botched the effort, in part because it picked terrible locations for expansion and loaded it with debt in the process. Eventually, it resorted to taking the unsteady company public and extracting a giant dividend payment in the process. A few years later, Fairway would enter bankruptcy for the first time, where it would pass to another round of private equity owners.
Theory 2: Private equity firms are especially terrible for industries experiencing upheaval, like retail.
Private equity firms specialize in two things: playing with debt and fixing up companies with basic operational improvements. In stable industries, that combo may work just fine. But in ones that are facing fundamental upheaval, it can be a disaster. Small moves like cutting costs won’t save a business. And huge debt loads make it hard to take more dramatic steps that might.
Brick-and-mortar retailers, which are fighting for their lives thanks to online competitors like Amazon, are a perfect example. Take Toys R Us, which ended up shouldering billions of dollars in new debt after it was poached by a group including KKR. The company was stuck paying hundreds of millions every year toward interest, which insiders say made it impossible to invest properly in the business and compete as Jeff Bezos’ kraken devoured the toy business.
There are, of course, exceptions. PetSmart seems to be doing well under the private equity firm BC Partners, in large part because it gambled by spending billions to buy online upstart Chewy, which it later spun off into a successful initial public offering. But for the most part, mixing private equity and troubled industries like retail seems to be a recipe for trouble. (For another sad example of what happens when private equity shops invade a sector with a fundamentally dying business model, see metro journalism.)
Theory 3: It’s too easy for private equity firms to borrow money.
There’s a third factor underpinning all this: cheap debt. Private equity has boomed over the past couple of decades in large part because borrowing has been incredibly inexpensive. More deals are inevitably going to lead to more disasters. But free-flowing credit may also be encouraging the industry’s worst habits. In “The Economic Effects of Private Equity Buyouts,” for instance, the authors found that after a leveraged buyout, companies tend to become more productive. But they see smaller improvements, on average, when borrowing is cheaper. How come? The authors theorize that “when credit is cheap and easy, it may be more attractive to rely on financial engineering tools to generate returns” such as dividend recapitalizations, instead of actually trying to make companies run better. In other words, easy money equals easy looting.
Put it all together, and you get a recipe for retail apocalypse. Cheap debt has led to a buyout boom, including in an industry where companies aren’t in a position to take on significant amounts of debt, and it’s simply easier for the private equity guys to shoplift whatever value they can. Expect more casualties soon.