How a Lack of Liquidity is Tanking Retail—And Who’s to Blame

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Unprecedented. That seems to be the most appropriate word for what’s happening to apparel retail today. With store closures and bankruptcies threatening to top recession levels, insiders, analysts and the media are all on high alert. One after the other stores like American Apparel, The Limited, Gordmans, Bob’s Stores and Payless are all disappearing from malls. Retail bankruptcies in the U.S. are already on track to outnumber the total through all of 2016.

The common culprits blamed for the retail flame out are a shift in consumer shopping habits and the rise of e-commerce sales. And while both have done plenty of damage on their own, one additional factor is responsible for making store chains less able to weather the tempest: a glut of leveraged buyouts that too often have become a business distraction and a financial drain.

Malls of America

With poor Q1 earnings results flooding in and the albatross of debt maturity looming for many, it seems clear this perfect storm will claim more victims.

“It will be a bloody year with no alternative until we downsize the department stores,” predicts Gary Wassner, CEO of factoring and finance firm Hilldun Corporation and InterLuxe Holdings LLC co-founder and chairman.

Wassner voices the opinion of many who recognize that the U.S. has too many stores. Real estate services firm Cushman & Wakefield reports the U.S. has nearly 23 square feet of gross leasable area per person compared to 18 square feet in Canada and six times more than the U.K.

What’s more, he says shopping habits have been evolving for a decade but stores failed to recognize the ways in which they needed to change. “What the stores did instead was promote and promote, and there were sales every day. It was a shortsighted solution to pushing product through,” Wassner says.

This tactic brought margins down and taught consumers that price was king, a lesson that made price transparency online all the more damaging.

This race to the bottom has been a hugely damaging factor, Wassner says. “I don’t think the retailers understood how much they were hurting themselves by over promoting product, so it wasn’t just the investors,” Wassner said, by way of identifying how we got here. “Everyone drank the Kool-Aid on luxury sales and [what they thought would be] the inevitable increase.”

What do PacSun, Aeropostale, BCBG and Wet Seal all have in common? They’re mall-based retailers, and for William Wilson, head of leveraged finance in the Investment Banking Group at Imperial Capital, that—even more than the current debt issues—is exactly the problem. “Mall-based retail is becoming an irrelevant model for the consumer,” Wilson said. “Nobody cares what the retailer thinks should be in the front window.”

Gone are the days when stores were the arbiter of taste and consumers blindly hopped on whatever bandwagon they presented. (Think head-to-toe safari gear at Banana Republic, for instance.) Now we all have everything at our fingertips, and we make our own decisions based on our tastes, convenience and yes, price.

While Wilson recognizes that capital structure is an issue for retail today, he contends the biggest problem is this business model. For example, he argues: “Neiman Marcus with no debt would have the same problem as Neiman Marcus with debt.”

Buyout blues

While it’s a fact that Neiman Marcus, like its competitors, is at a loss for how to woo shoppers, what’s also true is its debt is creating a stranglehold. The retailer, which recently put itself on the market, is currently in talks with would-be suitor Hudson’s Bay Company. That deal may never come to fruition, however, thanks to the $4.7 billion in debt Neimans is buried under following a $6 billion leveraged buyout by Ares Management L.P. and the Canada Pension Plan Investment Board in 2013.

Insurmountable debt caused by leveraged buyouts are causing a ripple effect across retail with stores closing doors, pondering bankruptcy and restructuring to protect their assets.

The most recent victim is Rue 21, which just filed for bankruptcy protection in a bid to restructure the $1 billion in debt from a $1.1 billion leveraged buyout by private equity firm Apax Partners in 2013. To try to achieve liquidity, the firm will also close 400 of its more than 1,100 stores.

Gymboree is also closing stores (around 350 of its 1,300 locations) in a bid to manage the $1.08 billion in debt it faces as a result of a buyout from Bain Capital in a $1.8 billion deal in 2010. Sources say bankruptcy may be the next step as $871.9 million of the total is due in under a year.

J.Crew, which was acquired by private equity firms TPG Capital LP and Leonard Green & Partners LP in a $3 billion leveraged buyout in 2011, has a $1.5 billion loan maturing in 2021 and $500 million in bonds maturing in 2019.

These private equity deals are making this an “historic” time, according to Howard Davidowitz, chairman of retail consulting and investment banking firm Davidowitz & Associates.

“We’re in a very complex problem with massive change,” he said, referring to convergence of consumer shifts and the e-commerce boom. “If you’re in that environment, do you think debt is going to help you?”

The question, of course, is rhetorical. From Davidowitz’s point of view, the retail industry is too volatile to be saddled with the financial responsibilities that come with repaying these huge sums.

“When you borrow all of this money there’s no room for any mistakes. There’s no flexibility,” he explains, saying it’s an untenable situation for retail, which is by its nature always changing. “You’re beholden to the banks and everyone else with covenants and all, so you can’t function.”

Cash flow crisis

The inability to function is directly tied to a retailer’s impaired liquidity, which is par for the course when fees and interest payments loom.

“Once you have debt and you constrain your ability to react, that’s where the problem lies,” Wilson agrees. For instance, cash-strapped stores can’t rehab older locations, implement new systems, invest in mobile or do any of the things necessary to adapt to the new environment.

Instead, he says, high debt burdens shift the focus away from actually running the business. “Management becomes distracted when so much of their time is spent managing and curating not product assortment but their own capital structure,” Wilson says.

If you’re in doubt, just read the quarterly results from Sears Holdings. Unlike its competitors who tout strategic changes like merchandising makeovers, boosting beauty and overhauling omnichannel, Sears’ public statements are centered almost exclusively around real estate deals and asset sales.

If you have a reported $596 million in debt that’s coming due this year and $1.29 billion in debt maturing in 2018 as Sears does, capital improvements must naturally take a backseat. For most companies this far under water, just doing the minimum becomes more of a challenge. For instance, just finding vendors to round out assortments becomes tough as they pull back to limit their own exposure.

“So in addition to having bad results and paying a tremendous amount of interest and fees and everything else, they’re not going to get the same terms they would get,” Davidowitz hypothesizes. “Everything is more difficult, and it results in needing more money at a time when your money is being drained, so that’s why they’re having to close stores.”

While debt that allows retailers to work toward an achievable ROI like the acquisition of beauty brand while that sector’s hot or the renovation of stores that results in experiential draws are fine—even necessary—Wassner says the problem with private equity is they’re not in it for the long haul.

“Investors today are only looking for an exit strategy from day one so they’re not committed,” he says. “The Nordstrom family has a big-picture perspective. Investors have short term goals that take precedence.”


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