While e-commerce competition certainly hasn't helped, a number of traditional retailers have been driven to bankruptcy by debt they took on as part of leveraged buyout deals (LBO). This type of transaction, which involves private equity investors acquiring a company with cash and significant debt, has factored into a number of chains closing their doors.
In this segment from Industry Focus: Consumer Goods, Vincent Shen and Motley Fool contributor Daniel Kline explain some of the basic mechanics behind an LBO work and why this type of deal can backfire, especially in a market where companies need to invest in order to compete effectively.
A full transcript follows the video.
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This video was recorded on March 22, 2018.
Vincent Shen: Anyone who actively follows the retail sector or has been listening to this show in the past year is likely aware of the challenges faced by retailers, especially those of the traditional brick-and-mortar variety. There's been store closures, bankruptcies, and the "retail apocalypse". They come up pretty often.
But in our previous discussions of these companies and retailers and the sector overall, we've addressed headwinds like online competitors, shifts in consumer spending and preferences, declining foot traffic, and the cost of some of these omnichannel investments. But what we haven't really touched on is the role that certain investors have often played in worsening the declines for some of these retailers. Specifically, I'm referring to private equity investors and how their playbook can end up hobbling a retail operation for short-term gains at the expense of the overall longevity of the business.
Dan, you came to me specifically wanting to cover this topic, so I'll pass you the baton. Can you give listeners, really quick, a high-level take on the situation? Once we have that framework, we can talk about some more specific examples.
Dan Kline: It's called a leveraged buyout. And what a leveraged buyout means is, let's pretend a company is worth $3 billion. The investors, the private equity, put up a very small amount of money, maybe $300 million. Then, they use the equity the company has to issue debt to then fund the purchase of the company. So essentially, they're taking a company that's very healthy, that has a great balance sheet, and they're saddling it with all sorts of debt.
That model made sense back in the early 2000s, when retail was sort of just a straight line. You couldn't see Amazon coming. You could look and see what was happening. And eventually that that would get paid down, the investors would make money. The problem is, when everything changed, the companies that had this huge debt did not have the leeway of, say, a Macy's or even, ridiculously, a Sears, to go, "Wow, all of these things are happening, we have to pivot." Now, obviously, some of those pivots didn't work. But if you look at certain retailers, they either limped along because they couldn't change and then eventually went out of business, or they're scrambling and closing stores and they just don't have the ability to get the money they need to make huge investments in order to change their strategy.
Shen: Yeah. I think, what this comes down to is the lack of flexibility that this kind of strategy ends up resulting in. And also, a lot of the changes that have come about in retail as a result of some of those other variables and headwinds that I mentioned earlier. At their core, though, the way these private equity investors operate is, one, they raise money from wealthy investors and large institutional investors to establish an investment fund. Two, they seek out underperforming or undervalued businesses, but they should have, as you mentioned, strong balance sheets, strong cash flows. Three, they acquire this business. Four, they make changes where they're trying to improve things like profitability and cash flow, and five, ultimately, they hope to profit through their investment through various dividends, management fees, and then sales or IPOs of those businesses to return that original capital to the wealthy and institutional investors.