Over the past 10 years, we have seen sweeping changes across retail that have had major implications for private equity (PE) investors looking to find value in the sector.
In the old days of PE investment in retail, creating enterprise value was relatively straightforward and typically based on four elements:
- polishing the core value proposition to ensure that it remained relevant;
- boosting digital and e-commerce channels;
- expanding both the domestic store estate and internationally through franchise and other models;
- ensuring operational excellence and tight cost control.
This was often supported by high levels of debt, of course. While these ingredients are still relevant today, it has become much harder to create a recipe for success that delivers sustainable value growth.
One of the key challenges is that the role of retail is fundamentally changing. Traditionally, bricks and mortar retail served as a point of distribution, often for other people’s products. Today, because it is generally more convenient to buy non-food items online, this role no longer adds value for the customer. Unless a retailer has something unique and experiential to offer, it is difficult to differentiate a mid-market proposition.
With value for money now the province of discounters or big online retailers like Amazon, one of the only points of differentiation left for traditional retailers is the customer experience, which can be difficult to achieve in a crowded middle market. Combine this fact with rising tax and labor costs and it is little wonder that we see so many mid-market retail failures. A real ‘muddle in the middle’.
Despite this gloomy outlook in the mid-market, there is value to be found on the edges. At AlixPartners, we have analyzed PE deals in retail over the last decade and drawn out a number of key trends. But what do they reveal for PE investors looking for value in the sector?
Luxury, discount and niche middle market
The luxury sector continues to command good valuations, with the global market benefiting from an increasingly wealthy middle-class in developing nations. There is also money to be made in value products, as strong performance by many discount retailers attests.
Additionally, niche mid-market brands are proving an exception to the norm. Many of those offering propositions that meet market niches very precisely – ranging from outdoor apparel and accessories to pet stores – are doing very well. Digital pure-plays offer the greatest EV potential, especially if they are luxury pure-plays.
Digital is complicated
For legacy retailers, digital has become a much more complex component of a value creation plan. It is no longer sufficient to just drive up e-commerce sales. Retailers now need to be technology businesses at their core.
This presents a major challenge for CEOs, who need to overcome the ‘shiny thing’ syndrome and choose the right technologies for their business to provide the best ROI. The economics of online retail are also becoming harder to manage, as customer acquisition through PPC spend becomes more and more expensive – essentially a replacement cost for bricks and mortar rent. Often, the unintended outcome of e-commerce success is shifting customers to a less profitable channel. This is clearly the wrong answer!
Less is more when pursuing international growth
The old model of international expansion, largely based on opening stores in multiple countries, is no longer relevant. Today, not only are there far more credible competitors in local markets, but a model that relies on franchisees adding 20% to the price of products is not viable in a world where price comparison is just a mouse click away.
There are a host of retailers who just a few years ago were lauded for aggressive and successful international programmes, but who have now been through some form of restructuring process. Many others have had to scale back and rationalise their international propositions considerably.
International strategy still offers potential for growth, but success is more difficult than it used to be. Those retailers that succeed focus on fewer territories and have clarity over where they are going and why. Less is more – less territories, more depth, more relevance and more profit.
A mixed record for private equity in retail
While some PE-owned assets – ranging from Liberty London to Watches of Switzerland – have been well supported, performed strongly and delivered significant value creation on exit, many others have overextended or succumbed to unsustainable debt burdens. As a result, the number of retail failures has escalated at a pace, fuelling multi-brand consolidators like Sports Direct and Edinburgh Woollen Mill.
While the jury is out on whether this distressed acquisition strategy will be successful, the synergies available to multi-brand, one-engine business models makes it hard for PE players seeking value to compete.
Fundamentally, what the analysis makes abundantly clear is that it is no longer possible to simply financially restructure a business and hope for the best with store openings or e-commerce growth. A relevant value proposition and operational transformation is required. This is the only way to drive EBITDA growth and the market relevance to support a decent valuation.
What does this all mean for private equity investors?
It is clear that the mid-market will continue to be squeezed. To succeed, operators need to head to the edges and reinvent their proposition around luxury, digital, discount, or specialty retail, or get out of the sector and try to recover as much value as possible.
For those that remain, significant value can be found in respecting the time-served ‘retail rules’ of customer focus, ruthless operational execution, and tight cost control. However, in this complicated world, new rules also apply.
It is imperative to innovate the proposition, develop a robust and focused digital strategy, and adopt a ‘less is more’ approach to international expansion. For those that have the appetite to look carefully and deliver genuine transformation, there is still significant value left in the sector.