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Debt financing for new retail leveraged buyouts is scarce

The wave of recent store closures and the retail industry's unpredictable outlook is dampening enthusiasm for debt to fund retail-related transactions, according to dealmakers and industry experts. Categories such as apparel, footwear and sporting goods are considered especially risky investments in the current environment.

As more retailers shutter stores and declare bankruptcy, the availability of debt financing for new leveraged buyouts, or LBOs, in the sector is becoming increasingly scarce. LBOs total a tepid seven deals to date in 2017, all conducted by private equity firms that invest in the middle market. Comparatively, there were 22 LBOs in the sector in 2016 and 27 in 2015, according to data provided by S&P Global Market Intelligence.

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LBOs have played a starring role in the retail industry's M&A activity over the last 10 years. In the retail space, such deals have been predicated on the idea that a brand will grow and open more stores. Opening new stores allows a private equity owner to grow the retailer faster than GDP, which justifies the leverage and provides the return, according to Greg Cashman, a senior managing director at middle market lender Golub Capital.

But store closings, rather than openings, have dominated the U.S. retail landscape in 2017. Retailers such as discount footwear player Payless ShoeSource Inc., contemporary fashion and accessories company Michael Kors Holdings Ltd. and electronics seller RadioShack Corp. announced plans to collectively close more than 3,000 stores. In light of the store closings, private equity firms will need to find an alternative rationale to both justify the large amount of debt needed to finance such transactions and to supply attractive returns, according to two bankers who work on such deals.

Beyond the bad headlines, private equity players have seen mixed results from some recent LBOs, including J.Crew Group Inc., Gymboree Corp. and Claire's Stores Inc., which are saddled with huge debt loads as they attempt to face challenging market dynamics that could persist for some time. Credit Suisse analysts said in April that they expect more than 8,600 stores to close in the U.S. in 2017 in response to increased online sales and decreased productivity of physical stores.

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Until some equilibrium is reached on store closures and the uncertainty is removed, Cashman said, deals will be sparse. If retailers, particularly those based in traditional shopping malls, cannot predict their traffic, then they cannot predict their revenue and provide guidance on future cash flow. It is through the ability to predict cash flow, and more specifically EBITDA, that financiers can surmise how much leverage can be placed on the balance sheet.

He pointed out that private equity firms "rely on the L in LBO to make the return math work."

Ellen Snare and Jennifer Daly, partners within the corporate law firm King & Spalding LP's global finance group, also see a softening in the appetite for term loan lending related to LBOs or privatizations. While there are quality targets, Snare said, the negative publicity around retail is making lenders cautious.

However, Cashman added that while raising debt financing is difficult, he does expect some retail deals to materialize, including LBOs. He noted that the U.S. retail space is peppered with a few strong performers, such as Party City Holdco Inc. and arts and crafts retailer The Michaels Cos. Inc., which continue to bolster confidence in the sector. But he anticipates that lower levels of debt will be utilized for takeouts in the sector.

Additionally, closing new transactions in the current retail environment means that bankers will need to be more creative if they hope to see retail-related deals come to fruition, according to the two industry bankers who work on LBO deals. One possible solution, they said, is to pair a high-yield bond offering with an increased asset-backed revolving credit facility.

There may also be options tied to carving out intellectual property, or IP, and other assets, said Michael Urschel, a partner at King & Spalding. "In the securitization space, healthy companies have been able to finance their IP and assets in ways that have been good for them, and it has allowed themselves to finance themselves at attractive rates," he said in an interview. Securitization is the conversion of an asset, usually illiquid, into a security that can, for example, refinance debt or raise cash. Franchised restaurant companies, for example, use IP securitization as a financing method, Urschel said.

"I think you'll find capital providers continuing to find creative ways to use securitization of IP and other important assets to find financing for a broader array of companies," Urschel explained.

There is a market for asset-based lending because it combines the cash flow needs of a revolver with a long-term financing structure, as well as more flexibility around the covenants but with a higher yield for the lenders, King & Spalding's Snare said.

Meanwhile, retailers with valuable real estate assets could appeal to investors. In 2015, private equity firm Sycamore Partners acquired Belk, a department store chain spread across the mid-Atlantic and the Southeast that also owns a great deal of its real estate. In June, Nordstrom family members controlling the department store chain that bears their name said they have formed a group to explore taking the company private. Not only does Nordstrom Inc. have valuable real estate, but the family's ownership of 31.2% of outstanding shares could serve as the equity component.

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For further M&A analysis analysis, check out the US/Canada Real Estate M&A Profile template in our template library.