If Productivity in the UK is Falling, Why are Private Equity Firms so Interested in Retail?

Citation

(2007), "If Productivity in the UK is Falling, Why are Private Equity Firms so Interested in Retail?", International Journal of Retail & Distribution Management, Vol. 35 No. 12. https://doi.org/10.1108/ijrdm.2007.08935lab.001

If Productivity in the UK is Falling, Why are Private Equity Firms so Interested in Retail?

If Productivity in the UK is Falling, Why are Private Equity Firms so Interested in Retail?

KPMG/SPSL Retail Think Tank – White Paper No. 4, April/May 2007

The topic for this White Paper was debated by the KPMG/SPSL Retail Think Tank (RTT) on 18 April 2007 during a particularly busy burst of activity for private equity (PE) takeover offers for retailers. In debating this issue, the RTT came to the following conclusions:

1. 1.

   The RTT does not think that the standard definitions of productivity are particularly helpful when applied to retail.

2. 2.

   The RTT does not fully agree that productivity in UK retail is falling or that it is much lower than in the USA and other European markets (as the government statistics would suggest).

3. 3.

   The PE industry is active due to increasing amounts of money flowing into the funds.

4. 4.

   PE investors look to generate returns through financially leveraging their investments and identifying business opportunities.

5. 5.

   Retailers' cash generation supports a financially leveraged model when the business is growing.

6. 6.

   The business opportunity presented to PE is not a function of low productivity but due to:

   • •

     in a private environment a retailer can more easily make “step change” business decisions;

   • •

     the opportunity of the investors to provide a significantly higher degree of constructive challenge to management than public investors can achieve; and

   • •

     the need for greater cash (as oppose to profit) focus in order to ensure financing needs are met, ensures business decisions are shareholder value enhancing.

7. 7.

   PE is generally a good thing for the retail industry and has provided the route to enable many small developing brands to grow, an incentive for others to sharpen up their acts and stimulated positive change.

8. 8.

   The “asset stripping” criticism is generally a misnomer (although there are exceptions). However, often property opportunities are a feature.

Introduction

The poor productivity performance of the European Union and the UK is something that continues to hit the headlines. According to AIM, a national research programme co-funded by the Economic and Social Research Council and the Engineering and Physical Sciences Research Council, productivity in the UK's business sector in 2001 was more than 40 per cent lower than in the USA. Statistics published by the University of Groningen in 2005 reported that while productivity growth in the USA accelerated from 1.3 per cent during the period 1980-1995 to 1.9 per cent during the period 1995-2003, in the European Union it declined from 2.3 to 1.3 per cent over the same time frames. The business sector held to be most responsible for the growing productivity gap between the USA and the UK is wholesale and retail, accounting for 19 per cent of the gap in 2001, up from 11 per cent in 1990.

So it seems that the UK retail sector, responsible for 6 per cent of the nation's GDP and 11 per cent of the workforce, is a principal contributor to Britain's low productivity and a growth rate lagging behind the G7 and many other OECD countries.

But is this a fair accusation? Is it a reason why PE groups have shown a voracious appetite for retail companies in the UK in recent years? This is the topic that the RTT set out to debate in its most recent sitting in April 2007.

The RTT argues that the low productivity attributed to the UK retail sector largely hangs on the way that productivity is defined. Policymakers and economists, including the Treasury, use labour alone as the key leitmotif of productivity. And on this basis, the RTT accepts that there is some evidence that labour productivity in UK retailing is lower than in some other countries. But it points out that cross-nation comparisons of labour productivity are fraught with difficulty. For example, in the UK the composition of retail employment is very different from that in the likes of the USA and France, where far fewer part-time workers are employed. The way that labour inputs are conventionally calculated in productivity measures also disadvantages the UK compared to many other countries.

Members of the RTT felt that productivity in the retailing sector really ought to be viewed in a broader context. “In my opinion” commented Prof. John Dawson, Universities of Edinburgh and Stirling, “productivity increase is simply getting more out of an asset for the same input, such as a labour cost but certainly other costs too”. So the RTT in its discussions favoured a more inclusive definition of productivity. In its view the restriction of using labour as the only input that is generally considered in an economic perspective of productivity, is too narrow a definition and casts the UK in a bad light, which is both unwarranted and not useful.

Retailing does not happen on a production line, where what comes off at its end is measured against the labour input along the line. It takes place in a complex environment, in which not only are there other significant inputs to consider, but also service aspects form a considerable part of the output. At the very least, the RTT argues, retail space should be factored in as another key input.

The main reason the RTT questions the Treasury's position on productivity is because trading conditions for retailers in the UK are substantially different from those in other countries such as France, Germany and the USA. For instance, the USA is far less regulated for planning, property, costs of building occupation and for business expansion. The fact, however, that the cost of occupying land is so high in the UK compared to many countries, and that land planning and regulations can restrict the size of retail outlets also work against retail productivity in the UK, even if land usage is taken into account.

Mark Teale, CB Richard Ellis noted that: “Planning is certainly one thing that makes the market so expensive here. As a result rental costs for instance are much higher than in the USA. This explains why businesses which operate in both markets, like GAP, can perform so differently here to there.”

In the UK, real productivity is masked by the very difficulties which Tesco and to a lesser extent the other supermarkets have been criticised for working so effectively to get around; namely acquiring (and stockpiling) suitable building land, obtaining planning permission for stores whose size and position makes economic sense and then building, staffing and stocking them with competitively sourced stock. In the USA, by contrast, the process is several degrees of complexity simpler giving many more players ready access to market and thus improving their apparent productivity versus ours.

It would be interesting to speculate how much more readily Wal-Mart (trading as Asda) might have taken on Tesco here in the UK if the “rules of play” were the same as at home. And it is as interesting to see how well Tesco will now perform in the USA as it now expands West, as well as East.

So even if one looks to a broader measure of productivity, the RTT accepts that the retail sector may not be as productive here as in some other parts of the world. This should not reflect badly on UK retailers, however, as it believes much of the explanation results from the composition of the workforce and planning regulations, neither of which are within the hands of retailers to control.

The RTT also points out that it is difficult in retailing, as in other services, to measure top-down productivity accurately, in either its narrow or broader sense, such is the paucity of accurate and timely data, particularly at a national level. Anyone with any experience of trying to collect labour statistics (for example) from a retailer will readily understand this. Adding the cross-country differences in data-collection methods and definitions make like-for-like comparisons even more difficult and thereby less meaningful.

Much of the debate about productivity centres on the input side. Output is measured either in gross output or gross-margin terms, but were one to view it as “value added” in its broadest sense then the calculation becomes even more difficult to do. The RTT argues that were this to be done, then the UK's productivity performance would improve substantially.

For all these reasons, the RTT considers that it is inappropriate to view productivity in the retail sector in the UK to be as low as it is often reported. Furthermore, the RTT is unconvinced that the productivity gap against other nations is increasing. The panel concluded that because the real numbers are masked by property and occupational costs and planning restraints productivity often looks worse than it otherwise would.

The RTT also rebuffs the notion, current in some quarters that any sense of poor productivity in the sector is the consequence of ineffective and poor quality management, low-labour productivity, lack of general competitiveness and the slow adoption of information communication technology.

If this were true, overseas players would have come in and rapidly succeeded here, and generally they have not. For instance, there are few examples where retailers are bringing in swathes of senior managers from overseas to replace UK counterparts. Instead the evidence is that UK-sourced management is now venturing abroad and not only for expansionist UK store chains such as Tesco but also for far smaller players such as Royal Stationer Smythson.

So just why are PE firms so interested in retail?

Tim Denison of SPSL commented that: “put most simply, the assessment criterion is whether the deal will deliver returns substantially above other mainstream asset classes, i.e. equities and bonds”. The first reason for the interest, the members all agreed, is because retail is a cash generative business. Goods are often sold before they are paid for and strong cash flow allows fast amortisation of debt and when coupled with rationalisation of assets can mean a speedy return for investors.

As Richard Hyman of Verdict Research succinctly explained: “In these days of progressively extending payment periods, a growing number of retail businesses are able to sell their stock before they pay for it. Most of these deals depend one way or another on borrowing large sums to do the deal and then using cash from the leaner, fitter acquired business to pay back the debt. The acquired company in effect pays for itself to be taken over. Retailers are better placed than most to facilitate this because they are so cash rich.”

PE houses look to capitalise on this fundamental strength of the retail sector by selecting their targets on the principal basis of two simple criteria. These are:

1. 1.

   the capacity demand for further significant rollout (estate expansion); and

2. 2.

   the potential for enhancements and extensions based on the strength of the brand.

Commenting on this, Paul Clarke of Barclays Retail & Wholesale Sectors explained: “Retail is `instant' compared to other businesses. It can happen very quickly. You can open new units, put on more sales, the growth opportunities are very good. The payback from capital investment in a new store can be within 18 months which compared to other industries is very quick.”

Interestingly, RTT Members did not agree unanimously that PE groups include a strong management team as a third criterion, quoting recent examples of retailers whose senior teams had been swiftly dismantled and replaced.

Secondly, the current level of interest is fuelled by the large amounts of funds available at their disposal and currently there to be invested. The ready supply of cash is driving demand for deals. Thirdly, building upon this, retail deals have had a great track record for the investor; there have been some spectacular successes, take Debenhams as a recent case in point. There are great potential opportunities to be had through very straightforward financial engineering.

A very strong motivator towards retail for PE groups can be a property portfolio of the target retailer. Its value is a big attraction, and cash flows from it are predictable. A PE firm acquiring a property rich company will almost certainly have as its number one priority to separate non-core from core business elements. Freehold property is just such a tempting element. Armed with a property portfolio it is a simple matter to sell the estate to the highest bidder and lease back the premises or to establish an OpCo/PropCo structure with greater borrowing capacity in the PropCo.

The target retailer itself thus provides huge sums of money to pay off some of the acquisition costs making it a very attractive target. Admittedly it does, by doing so, become freer to concentrate on its core activities. The downside is that it is saddled with ongoing rental fees which will have been negotiated at the time of the purchase and which, depending on the requirements of the PE firm for cash at the time of negotiation, may not be the most favourable possible.

The final reason for the PE interest identified by RTT members is the very fact that retailers are numerous, high profile, excitingly “rich” targets and can be readily assessed by not only looking at their published results but also by simply walking down any high street.

So is PE's attraction to retail a function of the potential to be had in productivity gains?

The RTT believes not in strict sense of labour-based productivity, but certainly once they have successfully identified, targeted and acquired a retailer, PE firms look to change three elements of that business as soon as possible. Helen Dickinson of KPMG calls this “sweating the assets”.

Element “Number One” relates to changing the financial structures, for example, the company's leverage. A lot of what PE houses do impacts cash flow much more than profitability because after the cash flow becomes more generative, they can decrease the leverage. They are less concerned by margin, therefore, than in keeping the mill turning. In other words, in the private arena, the focus is on cash flow whereas in the public market there is far greater attention given to profit.

Publicly quoted retailers have other concerns too. For instance, if a management team disposes of some assets, say by selling freeholds and concluding lease-back deals, the instant cash-flow boost will look good on the books for one quarter or one half-year but may make future trading look very lacklustre, opening up management to criticism. PE firms have no such qualms. If they decide to get instant results, a broad-based programme of disposal, rationalisation, improvement and optimisation is exactly what they will do from day one. With no public shareholders, as such, they are well placed to do it. As Helen Dickinson noted: “It's the difference between profits and cash. It's that simple. There is far more focus on short-term profit in the public arena. Far more on cash flow in the private.”

Vicky Redwood of Capital Economics agreed: “Like for likes are more important than cash flow in the public arena. In the private equity context there are no quarterly like for likes to analyse and sweat over; just cash and the growth potential. VC houses don't generally interfere in management in one sense, but in another sense are even more challenging than the City.”

Element “Number Two” takes up that point and centres on management excellence and its ability to improve the business's efficiencies. Paul Clarke noted that: “PE houses interested in retail know a lot about each company even before they attempt a takeover. They analyse the company at least ten times more than the company's own management team, so will often know more about the company that its own management. That's not a bad thing and certainly helps them guide the management when they acquire it.”

The new owners will quickly seek to deconstruct and reconfigure every element that can be subjected to efficiency improvements, from sourcing through to marketing, staffing through to suppliers. Under PE control retailers will certainly put pressure on suppliers. If suppliers are currently paid 30 days in arrears, the new owners will demand 60; if 60 they will demand 90.

“The Baugur model is particularly interesting”, commented Tim Denison: “It looks to make a significant rationalisation in the cost arena by building and sharing a back end, “big box” solution amongst its retailers, which spans their back office IT platform, e-commerce operations and HR functions.”

Admittedly many of these are things that quoted companies can do too, but their managers tend to be more cautious, more risk averse. Store management teams answering to the city and market investors more often than not believe that the short-term perspective taken by the market constrains them from taking anything but iterative-management decisions. There is little doubt that the market drives the current management of publicly quoted companies and it thus often may not be in a position to take the actions to accelerate the performance step changes that a PE house can and will.

However, Paul Clarke pointed out that Stuart Rose, a man who has successfully resurrected one trader's profitability while it is still a quoted company is neither averse to demanding more of suppliers, nor making bold step-change decisions; “This is not just any chief exec, this is the M&S chief exec” he noted. Nick Bubb of Pali International agreed that the management constraints on public companies should not be overplayed: “Tesco, although not a PE-acquired firm, has shown how well it is able to constantly improve the efficiency of retailing and never seems to question how far efficiency gains can be made.”

Vicky Redwood speculated that PE firms might, by their very presence, encourage public retailers to up their game, leveraging-up to put off PE takeovers and thus consciously removing some of their nascent tax advantages. Nick Bubb agreed, citing Topps Tiles which is now, he said; “highly geared in order to see off predators – and this in a market where gross margins are on average a whopping 62per cent.”

Element “Number Three” involves focusing on establishing the seed bed to foster value added output – the means to accelerate the delivery of sales growth, as a business imperative. Invariably this involves investment, whether it is to roll out a store chain nationally, build a brand's profile, or extend the reach in other ways such as online, licensing, spin-offs, new lines, etc.

So, in the final analysis, is PE good or bad for retail?

This is a question which our panel took some time to answer and of course, the answer can vary retailer to retailer, deal by deal. Good outcomes are certainly not rare. For instance, a deal such as Hobbs where the PE firm takes a somewhat longer term view and expands a business's profitability is generally seen as good by the RTT. In such deals everyone it seems is a winner; the PE house pays a premium so the shareholders are happy. The business is boosted by disposals, rationalisation, improvement and optimisation, so the staff and customers are generally happy, and even suppliers, though often squeezed on margin, can be delighted by increased orders.

Other PE deals are somewhat less satisfactory. Our panel concluded that many of these deals are led by large, generalist firms, often from the USA, some of whom do not fully understand the very real differences in trading conditions in the UK. Rent and occupational costs as well as complex and difficult planning restrictions leave many retailers locked into inappropriate and non-optimal aged properties with too little space and/or the wrong space. So there is scope for investors to be misguided in seeing an opportunity to introduce some swift “productivity increases” and “asset stripping” when in fact the results may not always match the expectations.

However, for all that, they can still do much that strengthens UK retail for all. PE houses will always be more challenging and closer to management and it is a universal truth that an independent oversight can put some real muscle into management. The challenge to the management of the business that they pose can thus serve the company and, through competitive pressures, the industry well. PE houses bring a different retail focus which can increase the ability of the retailer to take dramatic actions. Thus, PE deals can literally and almost magically transform a retailer's results.

The RTT concluded that PE firms get a bad name because of so-called asset stripping and yet many have looked to build the long-term success of their acquisitions; New Look and Hobbs being two examples of more positive stories. The RTT also noted that despite the growing media coverage of PE companies' frenzied interest in retailers such as Alliance Boots, Sainsbury, B&Q and Next, the number of actual PE deals (large deals involving large retailers) has actually declined over time.

Paul Clarke noted that: “There are fewer large PE takeovers in retail than even two years ago. Look at the statistics. Sure, the numbers are going up but there have only been six deals worth more than £50 million in 2006 and just five between £20 million and 50 million.”

Nick Bubb added that “lots of deals get talked about, few are concluded. Look at Woolworth's, HMV, Kesa and Sainsbury”.

Conclusion

The RTT deliberations have thrown up some interesting aspects of the PE takeover phenomenon. The RTT strongly disagrees with the government's position on productivity failings in British retail and has concluded that while there is always room for improvement British retail is not competing on a level playing field with its cousins in Europe and the USA and therefore it is not reasonable to make such comparisons.

The RTT also looked at why productivity in retailing in the UK appears to be falling. It concluded that using labour as the only input was too narrow a definition and distorted the outputs. The RTT concurred that the retail sector here may not actually be as productive as in some other parts of the world but that this should not reflect badly on UK retailers. It believes much of the explanation results from the composition of the workforce and planning regulations, neither of which are within the hands of retailers to control.

Looking at the effects of PE takeovers on retail the RTT decided that some British companies have benefited significantly by being taken over, going from strength to strength, others less so. Yet other retailers, finding themselves as possible targets, have been forced to up-their-game as a result of the threat they bring. PE companies with extremely short-term plans or ones based on overseas business models, it was felt, did not do well. Those who were prepared to “sweat the assets” did much better.

When considering why PE firms are so interested in retail our panel decided that being a cash generative business came first, closely followed by the opportunity to leverage assets such as freehold property and some way after that opportunities to extend the brand and instigate rationalisations. Whether PE firms ignore the longer term potential of retail businesses, is largely an issue of perception. Yes, “asset stripping” takes place but one firm's asset stripping is simply another's rationalisation.

So is PE good or bad? Our panel decided that on balance the flurry of takeover attempts on British retailers was a good thing, driving improvements throughout the industry. Ultimately the strongest and fittest retailers are those that will survive, be they takeover “victim” or successful public company seeing off a bid.

For further information, please contact: Theo Chalmers, Managing Director, Verve Public Relations. Tel: 01908 275271 or 07932 004632; e-mail: t.chalmers@vervepr.co.uk