How Texas Pacific Cleaned Up at J. Crew

The private equity firm reaped many times its investment by giving the preppy retailer the freedom that few public companies enjoy

by Steve Rosenbush

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Not so many years ago, the Gap (GPS) was a trend-setting retailer and J. Crew (JCG) was a small also-ran. In recent years, however, their roles have reversed.

Gap fired Chief Executive Paul Pressler in January, as the company struggled in vain to find its place in a crowded retail environment. Meanwhile, J. Crew has prospered under the leadership of CEO Mickey Drexler, the former CEO of Gap. J. Crew's stock has risen 87%, to $37.47, since its June initial public offering (see BusinessWeek.com, 6/28/06, "J. Crew's Smart-Looking IPO"). Gap shares are up 16% during the same period, with much of the increase due to speculation that Gap could be sold (see BusinessWeek.com, 1/8/07, "Gap on the Block").

What accounts for the difference in the fortunes of the two retail chains? The answer may very well be that J. Crew has benefited from a leveraged buyout by private equity investor Texas Pacific Group. The Gap has labored and wheezed as a publicly held company. "The J. Crew investment has worked out as a classic private equity play," says Phillip Phan, professor of management at Rensselaer Polytechnic Institute, an engineering school in Troy, N.Y.

TPG is one of a handful of elite "mega funds" that have the resources to make big deals and consistently get top results. It's the world's sixth-largest private equity fund, with $31.2 billion in assets under management, according to Private Equity Intelligence, a London researcher.

The Private Equity Advantage

The number of private equity deals has surged during the past few years (see BusinessWeek.com, 12/28/06, "Private Equity's Big Winners"). TPG's investment in J. Crew is a good example of why capital from pension funds and other huge investors is pouring into the private market.

Big private equity firms such as TPG generate huge returns on investment. TPG and J. Crew declined to comment for this story. As a private investor, TPG isn't obligated to report results to the Securities & Exchange Commission the way that mutual funds or other big, publicly traded funds are. But Phan, who has studied TPG and the J. Crew deal in particular, estimates that TPG made an annual return of about 32%. By stringing together one such deal after another, private equity firms can soundly beat the market. The average annual return for the Standard & Poor's 500-stock index is 8.65%, according to S&P (see BusinessWeek.com, 1/19/07, "A 'Public LBO' for the Tribune?").

Here's a look at how TPG was able to make the deal pay off: The firm bought 56% of J. Crew for about $125 million in 1997. Management owned the rest of the company (see BusinessWeek.com, 1/31/07, "Texas Pacific Has Great Run with J. Crew"). J. Crew's fortunes wavered during the next few years, but as a private investor, TGP was able to take several steps that public shareholders might not have understood.

Pruning to Spark New Growth

First, it hired Drexler not long after he stepped down from Gap in 2002, after spending 19 years with the company. The Gap was performing poorly and Drexler had taken much of the blame, but TPG had faith in Drexler's ability as a visionary retailer. It hired him to run J. Crew and gave him a huge incentive in the form of a 12% stake in the company. "Texas Pacific turned J. Crew management into entrepreneurs," Phan said. It's hard to imagine that public shareholders would ever stand for awarding a CEO 12% of a company, especially one who had previously presided over a troubled business.