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The Weird Love Affair Between TPG and J. Crew

What a strange love affair it's been between TPG Capital and J. Crew.

This morning the news broke that TPG Capital, with help from a Los Angeles private equity firm called Leonard Green & Partners, is close to a deal to acquire the preppy-clothing company for about $3 billion in cash, or around $43.50 per share. This news comes just 18 months after TPG Capital sold off the last of its previous stake in J.Crew at an average price of $14.

The turnabout, while continuing a convoluted TPG/J.Crew affair, also may speak volumes about the state of private money today.

TPG first acquired a stake in J.Crew way back in 1997. It was one of the private equity firm’s first and most notable deals. Back then J.Crew was a huge brand, with a highly recognizable name and look, but with sales of just $600 million per year. In the catalogue business, Eddie Bauer and Land’s End have sales more than twice J. Crew’s. Banana Republic dwarfed it in brick-and-mortar retail.

Perhaps even more importantly, J. Crew’s management—primarily the founder Arthur Cinader and his daughter Emily Woods—had an uppity reputation that had reportedly already scared off one buyer, Bahrain’s Investcorp.

The original deal was messy. TPG and J. Crew had agreed to a sale price of $560 million, financed with $175 million in senior subordinated notes with a 10 percent yield and $140 million in zero-coupon junk bond notes offered at 54 cents on the dollar. Chase would finance about $30 million in receivables.

But a strike by UPS hurt J.Crew’s sales, and TPG demanded a $20 million price cut.

Cinader balked at the price cut. The deal stalled, even as Donaldson, Lufkin & Jenrette and the Chase Manhattan Bank went to print with the bonds. When Cinader eventually agreed to recut the acquisition deal, the bond deals had already been cut. They had to be carefully renegotiated, with TPG putting in $20 million more in cash and the senior notes being cut down to $150 million. Chase agreed to finance some $39 million in receivables.

The company was acquired for $559.7 million, with around $188.9 million of cash coming from TPG and other private equity buyers. TPG took an 88 percent stake in the company. Cinander agreed to retire, while Woods stayed on.

Over the next few years, J.Crew suffered. It seems as if part of the strategy TPG attempted to pursue under the name of “fiscal discipline” was just cutting costs, selling assets and paying down debt. The management team put in place had little experience in fashion or retail. About 10% of J.Crew’s workforce was fired shortly after the deal. Meanwhile, J.Crew aggressively opened stores—despite the fact that same store sales were dropping.

The first CEO recruited by J.Crew resigned after just one year, reportedly after repeated clashes with Woods. Woods lost her position managing day to day operations, but stayed on as a board member. The new CEO was an executive from a frozen foods company.

The strategy appeared to backfire. Although cash flow rose, sales stagnated. Sales fell. Profits vanished, with the company declaring a net loss of nearly $12 million in 2001. EBITDA fell by more than one-third, to $53 million. Bond holders were becoming worried that J. Crew might not be able to make its interest payments when they came due.

The turnaround arguably began under Ken Pilot, a former GAP Executive. Pilot slowed down the opening of new stores. But bond holders remained nervous about the future of the company.

The turnaround really took shape in 2003, when TPG replaced Pilot with his old boss Mickey Drexler, the charismatic former GAP chief executive. Drexler, widely regarded as one of the top executives in the retail sector, had had a somewhat nasty falling out with the GAP after his strategy to attract a younger buyer seemed to fizzle. TPG eagerly snapped him up. He invested $10 million of his own money to buy the company’s convertible notes. TPG welcomed him on board by putting in another $10 million for convertible notes of its own. He was widely seen as the last, best hope for the company, and the mini-recapitlization of the company a needed boost after years of losses.

That view seems to have been right. Retail sales began climbing again. By the end of 2004, J.Crew operating revenue turned positive and losses were cut almost in half. Drexler was succeeded by going in the opposite direction of his predecessors and competitors—raising prices and quality at J.Crew and refusing the steep holiday mark-downs some of his competitors adopted.

In 2003, just three years after Drexler took over, J.Crew sold shares to the public at $20 a share. TPG and Drexler’s convertible notes returned a handy profit to both. TPG, however, was under a lock up agreement that prevented it from selling any of its stake until 2007. In fact, it re-invested capital it had earned out—including those convertibles—bringing it’s total investment in J. Crew to over $200 million.

TPG started selling as soon as it could. In a series of transactions from 2007 to 2008, TPG sold shares at prices ranging from $33.45 to $44.11 shares.

By September 2008, TPG was down to just 2.8 million shares. Then the world went to hell. Lehman collapsed, AIG was rescued, TARP was put in place, consumers all but cancelled Christmas. TPG exited its position the following April, selling shares for around $14.

Now, of course, TPG is back. It has been negotiating with Drexler to acquire a 75 percent stake in the company, with Leonard Green taking the other 25 percent. No doubt some shareholders will look with a skeptical eye at any deal cut between TPG and the man it put in charge of J. Crew.

But one question that hasn’t been asked properly is: Why is TPG buying a company it sold over the last few years? Why sell at all if they were just going to buy it back?

TPG is buying shares back for more than it sold many of them for. Buying high and selling low seems like an odd way to make money, to say the least. At the very least, it seems like TPG is risking more than all the money it ever made on J. Crew—$1.2 billion—to get back in the company it recently owned.

One private equity insider explained that this might all be a function of the way hedge funds need to appease investors.

“Even if they like a deal, there is pressure to show that they can exit. So TPG needed to show it could return capital to investors by IPOing and then selling down J. Crew,” he told us. He emphasized that in 2008, the pressure to sell was even stronger than usual.

Now, he says, the situation has completely reversed. The pressure is on funds to put their money to work.

“It was one of their best ideas ever, even if it took ages. Maybe they’re having seller’s remorse. Or just lack new ideas,” he said.

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