Private Equity Wins Even When It Loses, Thanks to Debt Markets

  • Buyout shops use borrowed money to pay themselves dividends
  • Many retailers struggling due to competition from internet

The Payless shoe company was already on its way to becoming another retail victim of the internet when the private equity guys showed up.

That the firms -- Golden Gate Capital Inc. and Blum Capital Partners -- weren’t able to turn Payless around after acquiring them in 2012 isn’t so surprising. That they’ve still made out so handsomely is.

As Payless shutters hundreds of stores and struggles to repay $665 million of debt, Golden Gate and Blum turned a profit on the deal. How? By having Payless borrow millions in the financial markets, a move that’s pushing the company to the brink. The firms have collected $350 million from Payless through debt-funded special dividends. Golden Gate and Payless declined to comment and Blum didn’t respond to requests.

Private equity firms have always borrowed to buy companies. But now, with debt so cheap, they’re layering on subsequent borrowing at an unprecedented clip to pay themselves, putting an additional, and at times fatal, financial strain on their newly acquired companies. From the start of 2013, private equity owners have taken out more than $90 billion in debt-funded payouts, according to data compiled by LCD, part of S&P Global Market Intelligence.

“Private equity firms are hastening the demise of companies that are already troubled by siphoning off money for themselves,” said veteran litigator Ronald Sussman, who has represented creditors in retail bankruptcy cases.

Online Shopping

Tough times for employees, bond investors and mall neighbors haven’t meant shared suffering for private equity executives. The signature Wall Street business of this century has reshaped companies big and small and, some say, ushered in a new era of American capitalism. In a testament to the industry’s rise, several prominent figures, including Stephen Schwarzman of Blackstone Group LP, are now advising President Donald Trump.

Certainly, the primary responsibility of private equity firms is to make money for their own investors, and sometimes that conflicts with what’s best for employees or bondholders. How they make the money is often dictated by the markets. If equity investors are clamoring for new stock, the businesses sell stock. If not, they can be recapitalized through a new debt sale to generate a dividend for the owners.

“You just sell them if the sale market is good, and if not, you recap them and you make money that way,’’ Schwarzman told analysts during an October 2015 conference call. “So we just sort of go with the flow, if you will.’’

Annual Returns

Private equity firms have generated 14 percent annualized returns after fees in the past five years, according to Cambridge Associates’s U.S. private equity index. That’s almost double the 7.4 percent returns on high-yield bonds in roughly the same period.

Retailers, who’ve been savaged by online shopping, just endured one of the worst holiday seasons in memory, with earnings in the fourth quarter declining for the third time in four years. Chains such as Macy’s Inc., Sears Holdings Corp. and J.C. Penney Co. are closing stores and already this year regional department-store chain Gordmans Stores Inc., outdoor outfitter Gander Mountain Co., and appliance and electronics seller HHGregg Inc. filed for bankruptcy. RadioShack filed for the second time.

Firms like Golden Gate, Sycamore Partners and Sun Capital Partners are among those that have scooped up retailers in debt-fueled buyouts. As the industry stumbles, some of the companies are getting choked by borrowing.

Mervyn’s Chain

Investors point to the collapse of department-store chain Mervyn’s in 2008 as a watershed. Just four years after private equity firms led by Sun Capital bought it from Target Corp., the chain was forced to shut its 175 locations and shed 18,000 jobs. Sun Capital and its partners, including Cerberus Capital Management, paid themselves $200 million by borrowing money through the retailer.

“They were after the dollars and evidently came out quite well,” said Mervin Morris, 96, who founded the chain in 1949. Losers were the stores, which “couldn’t sustain the additional debt they put on,” he said.

“They broke my heart,” Morris said.

In a strategy that’s been repeated by other private equity firms, the owners split Mervyn’s real estate properties and its retail businesses, forcing the shops to pay higher rents and pocketing the gains, Morris said. In 2012, creditors won a breakthrough settlement for the chain’s collapse.

“We all thought this would change the behavior of private equity firms,” said Eileen Appelbaum, senior economist for the Center for Economic & Policy Research in Washington. “Turns out, that wasn’t the case.”

Balance Sheet

Doug Allen, a spokesman for Sun Capital, said the firm sold three retailers last year that remain thriving businesses even after they distributed cash to investors through debt-funded dividends. “As we can see across the current retail landscape, the business challenges that lead to a Chapter 11 filing are often broader and more systemic than a decision to return capital to investors,” Allen said.

In 2014, Lone Star Global Acquisitions took a $180 million dividend from the balance sheet of South Carolina-based supermarket chain Bi-Lo Holdings, just as its prospects began to falter. The company’s 2013 bonds, that were used for an earlier payout, are now trading at a level which indicates investors expect to recover less than half of what they paid. 

The same year, Sycamore Partners’s Nine West borrowed $445 million from loan investors partly so it could reduce its equity stake in the company. And last week, 102-year-old discount retailer Gordmans Stores filed for bankruptcy less than four years after Sun Capital borrowed money to pay itself a dividend.

Representatives of Sycamore, Cerberus and Lone Star declined to comment.

Paying Themselves

Paying dividends has become increasingly important to buyout firms that can’t sell their flagging businesses back to the public markets or to peers. If a firm can show its investors it’s generating returns from investments, even struggling ones, then it has a far greater chance of raising new money, said a senior private equity executive who didn’t want to be identified discussing strategy.

Retailers usually borrow for dividends while they’re still making money. That enables the private equity firm to pay down debt, then borrow more, called re-levering, said Frank Maturo, vice chairman of equity capital markets at UBS AG in New York. 

Cash Flow

“So if the cash flow is there, they could take out whatever they need to take out” to show investors good returns, Maturo said. The buyout firms “keep taking out dividends so they’ve gotten all their investment back. Then it’s just gravy and they just keep re-levering it.”

It’s later, after sales sag, when it becomes apparent that the company is carrying too much debt.

“You can lever up an asset tremendously and return that cash back to shareholders in a heads-I-win, tails-you-lose,” said Brent Beshore, who runs Columbia, Missouri-based adventur.es, which buys equity stakes in small private businesses. “It’s a great gig if you can get it.”

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