Can private equity save embattled retailers?

From the C-Suite newsletter: Buyers have swept in to save MEC and Frank & Oak. What they do next will be critical to survival.

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This article is the second in a series on surviving bankruptcy protection during COVID-19. You can read part one, exploring strategies to kickstart the recovery process, here

In the week since strategy published an article looking at retail bankruptcy recoveries in the era of COVID-19, another major retailer joined the growing list of Canadian and U.S.-based companies toppled by the pandemic.

Montreal-based fashion chain Le Château had already warned of its potential demise. In July, as it negotiated with lenders and sought new sources of financing, it said it would have difficulty remaining in business. Now, after more than six decades in Canada, it plans to permanently close all 123 stores across the country.

While Le Château will not outlive the pandemic, other struggling retailers have been spared – temporarily – by private equity.

After obtaining creditor protection in September, outdoor goods retailer MEC agreed to be sold to U.S.-based private equity firm Kingswood Capital Management – ending its status as a cooperative, which it has held for nearly 50 years. A month later, as part of its bankruptcy protection filing, Montreal-born Frank & Oak’s operator, Modasuite, agreed to be acquired by U.S.-based Unified Commerce Group (UCG), a newly established company that intends to buy and scale a number of retail brands.

Without an injection of capital, MEC and Frank & Oak may have been forced to shutter their operations entirely. But will new owners be their salvation?

“There’s a long, long list of brands that have been destroyed by private equity,” warns Doug Stephens, retail expert and founder of the Retail Prophet. “[It’s] often not the cure-all that we would hope for.”

That sentiment is echoed by Randy Harris, president of Trendex North America and publisher of Canadian Apparel Insights. He says it’s almost never a good sign when private equity swoops in to save a faltering business.

He says there are exceptions, such Stern Partners-owned Comark Inc, which runs Ricki’s, Cleo and Bootlegger stores. Although the chain has recently run into trouble, filing for protection in June, the monitor’s report notes the private group had previously taken “proactive steps” to fight declining sales, including opening 21 new stores in the last three years and “making capital investments in its in-store shopping experience.”

And, sometimes, going private can help a company invest in turnaround efforts free of the “day-to-day whims of shareholders as well as quarterly earnings reports, which pressures retailers to post continuous growth rather than make operational changes that may hinder sales in the short-term but serve its longevity years down the road,” as the Business of Fashion has speculated could be the case with the Hudson’s Bay Company going private.

But, in his experience, Harris says a lot of private equity firms eventually rush to “get their money out and run to the door.”

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The trouble with private equity

Private equity takeovers can heap significant debt on a retailer through what is known as a leveraged buyout, in which the assets of the company being acquired are used as collateral in the deal. This can be the first sign of trouble, according to Stephens, as it can leave a company vulnerable and unable to overcome market shocks.

For example, American department store Neiman Marcus had roughly $5 billion of debt on the books (after two leveraged buyouts from private equity firms) when it filed for protection in May. That put it in a vulnerable position and, according to CEO Geoffroy van Raemdonck, unable to cope with the “unprecedented disruption” of COVID-19.

Beyond the debt accrued from a takeover, trouble can arise if a private equity firm acquires a business with plans to offload it at a later date. “A lot of really destructive decisions can be made in that process,” Stephens says, “most of which involve downsizing.”

As MEC’s new owners, Kingswood plans to keep a minimum of 17 of the retailer’s 22 stores, according to the Globe and Mail. And prior to being acquired, Frank & Oak operated 20 stores across Canada and was looking to close as many as 17 locations, according to Betakit. The chain’s pre-COVID financial troubles were largely attributed to the unprofitability of its physical stores.

“Your stores are one of the most powerful forms of media that your brand actually has,” Stephens says, adding that even unproductive stores can drive online sales. “While you’re trying to take out these – at least on paper – unproductive stores, what you’re not capturing or measuring or cognizant of, is the impact that those physical stores actually have on your overall brand awareness.”

Harris has seen many companies close the majority of their stores with the intention of going e-commerce only. For example, after filing for bankruptcy protection in July, Toronto-based Mendocino said it would close “all or substantially all” of its 28 stores in Canada to sell its women’s clothing almost exclusively online.

“In the short term – maybe [it makes sense to close],” Harris says. “But in five years from now, you want to be around. So anytime you see a company saying, ‘We’re closing all the stores, we’re just going to have ecommerce.’ That to me is just a very short-sighted strategy.”

When a new owner comes in with plans to turn a company around on the short-term, they typically begin downsizing and cutting costs, says Stephens. Often, this means they aren’t innovating, which in itself can be “fatal,” considering how quickly the retail industry has evolved over the last 10 years. When Toys R Us  filed for bankruptcy in 2017, it was paying $400 million per year in interest payments on its $5 billion of debt – a burden that prevented it from innovating fast enough to compete with Amazon and Walmart.

Eventually, Stephens says, the company realizes it has spent too much time shuttering stores and rationalizing the workforce, rather than keeping up with market changes or building new bridges to consumers. “At the end of the exercise, what happens? You say, ‘Our sales are still shitty. We’re still not profitable. So guess what? We have to cut some more.’ Then it becomes a downward spiral.”

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What does this mean for MEC and Frank & Oak? 

UCG describes itself as a “retail acquisition and advisory group designed to drive innovation in the retail industry.” It says Frank & Oak is its first strategic investment, though its website also lists Radley London, Lisa Von Tang and Velveteen as among its brands and partners. And the new company has ambitions for the brand, with plans for expansion to the U.S. and Asia.

This, Harris believes, could be a mistake.

The expert says UCG should “forget about going after the U.S. nationally,” because that would be “an absolute bad business decision.” If anything, he says, it should focus its efforts on no more than two or three major U.S. cities. But, more realistically, it needs to “solidify their base in Canada first, where they have a high recognition, and build up that business.”

The company lacks the brand awareness needed to go after a market as large as the U.S., he says, even if it plans to take an ecommerce-first approach to the market (as it did in Canada). “You’ve got to build awareness first and that’s difficult to do without spending a fortune on advertising and marketing and opening new stores.”

As for MEC, Harris believes the amount of negative publicity around the company’s takeover could hinder its recovery process. He said last week that some retailers might be spared the negative publicity typically associated with bankruptcy protection, simply because so many retailers find themselves in a challenging position right now. But it’s different with MEC: “Everybody that belongs to the MEC co-op is aware of MEC’s situation.”

Similarly, Kim Koster, brand strategist at Koster Strategy, says some retailers can afford to move on from reminding customers of their struggles or ownership changes. However, this is not the case with MEC, whose ownership structure has always been a key part of the brand.

Koster notes that the outdoor retailer consistently ranked among Canada’s most-trusted brands. (Research suggests this was in part due to MEC’s former co-operative model.) But since the takeover by Kingswood Capital, the company has faced a revolt from its own members. Members who objected to the deal signed a “Save MEC” petition, raised funds and hired legal representation in an attempt to fight the sale in court. (It has since been approved by a judge).

The company’s new leadership says it’s aware that members’ connection with the brand is stronger than is typical in retail. In an interview with the Globe and Mail, CEO Eric Claus said it intends to “make sure that whatever we do, we keep supporting people that were members, and give them real value for their loyalty,” adding that MEC is a “really trusted brand in Canada, and we are now the stewards of the brand.”

So where does it go from here?

First, Harris says MEC management could go on a “listening tour” with store managers and employees to “find out exactly what their consumer is saying and what they think they should do about it.” Then, the company’s leaders could proceed with an “apology tour,” in which they “talk about why this happened, do a mea culpa, say it could have been handled better and talk about where the company goes.”

In other words, it needs a PR fix to its PR problem, he says, because “if there’s been a case where a retailer shot itself in the foot in the public domain – this is a prime example.”