Given the increased level of private equity interest in UK retail because of strong consumer demand and cashflow, negative working capital – i.e. selling goods before having to pay suppliers, from mainly self-owned estates – it is perhaps useful for NAMs to understand how a major customer relationship will change as it moves from traditional to private equity ownership…
What is PE in Retail: Private equity (PE) is a form of takeover, usually buying a retailer via borrowing, selling off assets (meaning retail estate) and leasing back what is necessary to conduct the business, heavily incentivising the current management team to encourage continuity, a uniform focus and active acceptance of a smooth purchase, with up to a five-year exit window via re-flotation or sale to another PE company. In the UK, the double whammy of Lockdown and Brexit has made the UK mults even more attractive to PE companies.
Incidentally, when the target is too big for a single PE company, two may combine for the acquisition. This may further complicate a NAM’s future business dealings…
In understanding the PE business model, it is vital to appreciate the importance of EBITDA as a fundamental PE measure of the value of acquisitions and disposals. It is important to take EBITDA into account in your dealings with the mults, given it is one of the most important measures in PE dealings. As you know, Earnings Before Interest, Taxation, Depreciation and Amortisation (EBITDA) represents a radically different way of running and measuring a business and in the case of retail will materially affect the balance of their needs from suppliers…
Essentially, whilst traditionally-run companies are measured via a combination of ROCE, driven by pre-tax Net Margin (i.e. P&L), and Rotation of Capital (i.e. Balance Sheet), driving via EBITDA means borrowing as much as possible to acquire the retailer in order to set Interest against Corporation Tax on earnings to minimise/eliminate future tax. Two key areas for PE companies are Operating Expenses (wages, equipment leases etc.), which lower EBITDA and Capital Expenses (buying rather than renting vehicles, equipment) that don’t affect EBITDA. So a PE company will try to reduce operating expenses and increase capital expenses (NB. An exception is investing in buildings as it ties up capital longer-term and reduces flexibility, so Sale & Leaseback of stores is attractive to PE companies).
Where is PE headed: The PE company comes with a five-year (or less) exit strategy already in place i.e. reselling of the retailer via re-flotation or sale to another PE company. In traditionally owned retailers, the focus is on optimising ROCE, capital rotation and margin, to make the re-flotation offering as attractive as possible to the stock market. However, the key PE driver is improving EBITDA because the selling price will be determined as a direct multiple of EBITDA, ignoring costs such as Interest, Tax, Depreciation and Amortisation. Everything else is secondary.
In practice, they improve EBITDA by attempting to grow the business by a combination of Organic Growth, Increasing Margin and Acquisition:
- Organic Growth can be the best source of extra business for suppliers (apply Ansoff).
- Margin can be increased via cost reduction, sales price increase (using innovation to add value but otherwise difficult to raise retail prices in a discounter, price-war environment, post-Lockdown) – therefore there will be increased pressure on supplier prices, reducing running costs and cutting out waste).
- Acquisition of extra retailers (to optimise scale advantages) does not directly affect the NAM except in the event of Prices & Terms disparities being discovered in the new acquisition.
One example of the issues surrounding PE retail acquisitions is the difficulty Morrisons are having in agreeing a formula combining the enforceable interests of key stakeholders: ‘colleagues, customers, pension trustees and suppliers as well as the distinct heritage and history of Morrisons and the legacy of Sir Ken Morrison’.
Impact on the NAM: The customer’s management team will focus on fast financial returns, short term performance, anything that improves EBITDA. All initiatives must provide a return within the five-year window. Forget anything longer.
What action is required: Apart from coping with fighting new fires day-to-day, it is important that the NAM takes over the strategic element for their brands to compensate for the short-term focus of the retailer’s team… Finally, keep in mind that the customer may end up being bought by a rival, so anticipate possible Prices & Terms disparities.
Not simple, but ‘doable’…
