It's more than Amazon: Why retail is in distress now
- 2017 is on a record-setting pace for retail bankruptcy and store closings.
- Chapter 11 bankruptcy is now turning into liquidation much more frequently due to law changes.
- Half of the retailers who have filed for Chapter 11 protection were owned at least in part by private equity.
With more than half of 2017 still ahead, the retail industry is seeing a record-setting pace for bankruptcy filings and store closings — and more are expected in the not too distant future, despite what most consider a healthy consumer.
This tipping point for retail is the result of a number of compounding reasons, but the inability to pay looming, massive debt bills is dealing the final death blow to many.
More online shopping
Yes, more shopping is shifting online in general, and to Amazon specifically, as in-store shopping traffic and sales trends fall for many retailers and shopping centers. Slice Intelligence said 43 cents of every online dollar is spent on Amazon, based on its analysis of millions of email receipts.
However, according to the latest Commerce Department retail sales data, 86 percent of all retail sales (excluding motor vehicles and parts and food service and drinking locations) are still made in physical, brick-and-mortar locations. To be sure, the online versus in-store sales breakdown varies wildly from retailer to retailer.
Less stuff, more experiences
While some shopping is shifting from stores to the web, spending is being diverted from physical goods, particularly, clothing.
In 2005, 3.6 percent of total U.S. retail sales went to department stores; now it's less than 2 percent, according to government data. Retailers like Macy's and credit card companies have discussed the shift in consumer spending from physical goods to experiences like travel.
Plus, for years now, Americans have been making bigger purchases or investments like their homes, which has paid off for Home Depot and Lowe's. But other spending categories are also rising, including health care and education. Additionally, many consumers are now shelling out for smartphone data plans and subscriptions to services like — all costs that take away from other disposable spending categories.
Bankruptcy code changes
But retail's trouble goes beyond the secular changes in consumer behavior.
Major changes to the bankruptcy code went into effect in late 2005, largely shifting from debtor-friendly to creditor-friendly after successful lobbying attempts on behalf of creditors and in the case of retail, landlords.
Retail restructuring experts say what the changes ultimately boil down to is a lack of time to turn around a struggling business once a Chapter 11 bankruptcy filing is made. The law now allows a maximum of 210 days for retailers to inform landlords if they are going to renew leases or close doors.
Before the 2005 changes, it was not uncommon for a retailer to be in bankruptcy for 18 months or so, but now that's not possible. Which means, Chapter 11 is now turning into liquidation much more frequently.
"I took [grocery chain] Winn-Dixie through the restructuring process in [February] 2005. It took 16 months, but it was an ultimate success," said Holly Etlin, AlixPartners managing director. "The bankruptcy law changes went into effect at the end of our restructuring. It likely couldn't be done under the law today."
Etlin is also the current chief restructuring officer at women's apparel retailer BCBG Max Azria as it works to restructure after filing for bankruptcy on Feb. 28.
"When the law changed, it immediately had a very severe effect on the ability of retailers to reorganize" explains Lawrence Gottlieb, a bankruptcy attorney and retail sector expert at New York law firm Cooley. The firm has represented a number of creditors in the bankruptcy filings by Eddie Bauer, Filene's and Samsonite Stores, and represented some debtors, like Crabtree & Evelyn.
Gottlieb led a 2013 study of 45 retail bankruptcies, analyzing and contrasting the outcomes pre and bankruptcy law changes. Half of the 20 retailers studied that filed for bankruptcy pre-2005 law changes, successfully restructured debt and emerged from bankruptcy, 15 percent were sold, and 35 percent liquidated.
Conversely, only 12 percent of the retailers filing after the law changes successfully restructured, with 40 percent selling, and half liquidating. Gottlieb has not updated his study but says the fundamental analysis remains the same.
It's important to understand that retailers rarely fail overnight. In most cases, a lot of the operational trouble, including declining sales and traffic began before the Great Recession.
When the recession hit, shopping center landlords began giving concessions, like lower rent or better lease terms, to retailers hoping to fend off the fears of ghost malls devoid of retailers and shoppers. Some restructuring experts say a number of these retailers should have filed for bankruptcy during or shortly after the recession, but were able to hold on thanks to loans in received in the form of debt at historically rates.
"There was a huge availability of capital and concessions made to retailers during the recession, which kept them hanging on," said Michael Appel, president of retail restructuring practice Appel Associates. "The problem though was it allowed retailers to keep doors open, but without making management or operational changes. Now for many, there's nothing left."
Appel was chairman of Loehmann's while it attempted, though ultimately failed, to restructure. The retailer liquidated in 2014.
"You can do a financial restructuring, but if you don't have a defensible business proposition, you get liquidated anyway," he said.
Now, those debts are reaching the end of their runways, meaning it's time for retailers to pay their creditors. The problem is, the debt loads are bigger than many can handle, and there's no time left to make up the cash needed.
Massive debt ... thanks to private equity
Half of the retailers filing for Chapter 11 this year are owned at least in part by private equity, and the pattern is expected to continue. Moody's has a number of other retailers owned at least in part by private equity on watch lists based on upcoming debt maturities, including J. Crew, Neiman Marcus, David's Bridal, rue21, Claire's and Charming Charlie.
Even David Simon, CEO of mall operator , who unsurprisingly often plays a cheerleader role for positive retail trends, can't deny the impact private equity is having on retailers.
"The [retailers] that aren't surviving in a tough REIT apparel environment are the ones that were highly levered and had the imprint of private equity on it," Simon said on his most recent earnings conference call. "If you look at, kind of, where that pressure point has been, it's more than just our apparel business is bad, it's because, well, they couldn't survive with leverage on it."
How is it that so many private equity investors — known for having some of the smartest minds in finance — missed the impending degradation of the sector?
Decades ago, it was among the most popular of leveraged-buyout plays. The popular notion was that these firms could buy a retailer, make the business more efficient while expanding its footprint in new markets, and then sell the company or take it public at a higher price.
It didn't always turn out that easy.
David Bonderman, the chairman and founding partner of TPG Capital, summed it up at the Milken Institute Global Conference in Los Angeles this week: "The internet has proven much more resilient and much more important than most of us thought a decade ago when this started to happen."
Bonderman was speaking about retail, an industry he said he now plans to avoid.
Turns out, the challenge for many retailers was that they racked up such high-interest payments that they were unable to invest as heavily in e-commerce or other areas of the business.
"Because of the pressure to generate returns, they constructively do something that effectively burdens a company with so much debt, it can't sustain that debt," said Ron Sussman, a former bankruptcy litigator who focused on retail. "When it tanks, it's only the PE guys and gals who make it out."
While the bankruptcies of some retailers have cost private equity firms millions, in aggregate, the industry's retail investments have been positive. Between 1997 and 2014, pooled gross returns for private equity investments in the retail sector have never been negative, according to data compiled by Cambridge Associates, an investment firm. In 2013 and 2014, the sector returned 28 percent and 25 percent respectively.
One way private equity has been able to salvage these investments is through dividend recapitalizations. These are effectively payments made to the private equity owners additional debt placed on the retailer. Given the openness of the financing markets over the last few years, these dividends have become fairly common.
This year, such loans issued by retail companies to finance dividends to private equity amounted to $2.7 billion, according to LCD, an offering of S&P Market Intelligence. That compares with $1.65 billion in all of 2016 and $3.17 billion in 2015.
It's impossible to know what retailers like Payless, which filed for bankruptcy earlier this year, would have looked like without private equity backers. But the mountains of debt and several turns of leverage did not help.
Either way, the confluence of these factors leaves Gottlieb asking: "If you are a retailer in distress, how in God's name can you come out of it?"
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