Markets & Finance

Private Equity Takes a Shine to Retail


Just a few years ago, private-equity firms viewed the retail sector as risky territory. While deals in the sector were hardly unknown, they weren't as sought-after as private-equity mainstays such as industrial parts.

That perception has shifted radically. Private-equity players are now approaching the retail sector with fervor. The latest sign occurred on July 5, when Blackstone Group and Bain Capital teamed to buy craft-store chain Michaels (MIK) for $6 billion. The group beat back a rival bid from another pair of private-equity giants, Kohlberg Kravis Roberts & Co. (KKR) and Texas Pacific Group.

The Michaels deal follows several other big transactions in the retail market. KKR and other firms agreed to buy Toys "R" Us last year for $6.6 billion. Texas Pacific and others agreed last year to buy luxury merchant Neiman Marcus for $5.1 billion.

ENCOURAGING RESULTS. Private-equity activity in the retail sector will continue, industry experts say. Over the last few years, retail deals have actually worked out well for these investors, and that has encouraged others to give it a try. Bear Stearns Merchant Banking (BSC) acquired the Aeropostale business from department-store chain Federated (FD) in 1998.

Aeropostale (ARO) went public in 2002, generating a handsome profit for Bear Stearns. Texas Pacific and other private-equity players bought Burger King from Diageo (DEO) for $1.5 billion in 2002 and made a big profit in an IPO earlier this year (see BusinessWeek.com, 2/2/06, "IPOs Have It Their Way").

"You are seeing a lot of people who never did retail deals join the fray. That's because there's been a fair amount of success in the sector," says Richard Perkal, a senior managing director at Bear Stearns Merchant Banking.

BRING IN THE BULGE BRICKET. Private-equity experts such as Perkal believe the bulge-bracket investors such as Blackstone, KKR, Texas Pacific, Bain, and others will be drawn to national franchises. That's because powerful brands that dominate their market help insulate the buyer from risk. "If you can buy a company that dominates its market, the success of the deal really hinges on demand for the product. If you analyze the demand properly, you can do very well," Perkal says.

That doesn't mean that megadeals are likely. The largest private-equity funds such as Blackstone have about $15 billion under management. They won't put more than 10% of their capital in any one deal, if that. Once each firm chips in its portion of cash, and the cash is supplemented with debt, a consortium of big private-equity players can have trouble buying companies for more than $15 billion. That doesn't mean that a few supersize private-equity deals won't happen, but they won't be routine (see BusinessWeek.com, 6/13/06, "Fresh Barbarians at the Gates?").

Who might be next? Here are six examples of the kinds of companies that industry insiders believe might make logical targets for private buyouts. While no one is saying that anyone is in talks to acquire any of these companies, they are viewed as good strategic fits for large private-equity firms.

Domino's Pizza, Papa John's

Private-equity interest in the restaurant sector has picked up recently, thanks to recent successes such as the Burger King (BKC) IPO. France's Pernod Ricard agreed to sell its Dunkin' Donuts group, which includes the Baskin & Robbins ice-cream business, to a consortium of private-equity buyers for $2.4 billion (see BusinessWeek.com, 12/20/05, "Of Donuts, Debt, and Deals"). Domino's (DPZ), with a famous brand and a market-leading share of nearly 20% in the home-delivery market, could be a target. The company has been a solid performer since its initial public offering two years ago. And with a market cap of $1.5 billion, a pair of big private-equity firms could split the company as a snack.

Still hungry? How about another slice? Papa John's (PZZA) has a strong brand in the restaurant market. And with a market cap of $1 billion and a solid record of sales growth, the company looks like a reliable generator of cash, too.

Barnes & Noble, Borders

Barnes & Noble is nearly ubiquitous across the retail landscape. A fixture at malls and shopping districts, the bookseller has a market-leading share of 15%. With a strong brand that has been extended into music and other goods, Barnes & Noble could provide a buyer with a nationwide retail platform. With a market cap of $2.3 billion, the company would be a viable target for even a group of midsize private-equity companies.

Rival Borders provides a nationwide platform, too. It has a presence online, although that's maintained with partner Amazon (AMZN). But the No. 2 book dealer, which also operates Waldenbooks, has had a rough go of it lately and its losses have been at the higher end of expectations. The company, with a market cap of $1.22 billion, could be a classic turnaround play for a private-equity investor.

PetSmart, Petco

PetSmart (PETM) is the leader in the U.S. pet-supply business. The company, with a market cap of $3.52 billion, would be a substantial target, although its share price has been battered of late because of concerns about rising price competition in the industry. With a strong brand and solid fundamentals, a private-equity investor might view its current troubles as an entry point for a turnaround. Rival Petco (PETC), with a market cap of $1.17 billion, has been putting the pressure on its larger rival by cutting its prices.

And both companies face pressure from big, diversified retailers such as Wal-Mart (WMT) and Target (TGT). That has made shareholders nervous. Private-equity investors, who are focused on cash flow as opposed to sales growth, might have more of a stomach for the increasingly competitive business.

OfficeMax

A buyout of office-supply giant Staples (SPLS), with a market cap of nearly $18 billion, would be doable. But it's not likely to happen. Its smaller rival OfficeMax (OMX), with a market cap of $2.8 billion, represents a much more practical entry into this realm of the retail market. The company has outperformed investor expectations in recent months, and that has caused the stock to soar. Standard &Poor's downgraded the shares to sell earlier this year after a 30% runup. But the market remains highly competitive, and if the price takes a hit in a volatile market, a buyout firm might take a good look.

There always will be risks in the retail environment. Customer trends are hard to predict, competition is tough, and a swing in the labor market or the price of gas could spook consumers and depress spending. But the recent spate of successful buyouts has convinced more and more private-equity investors that the risks of retail are worth taking.


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