Combine two leveraged buyouts with $5 billion in debt. Add a pandemic. Stir. 

If anyone, for whatever reason, were in need of a recipe for retail bankruptcy, the above is as good as any. It was enough to send Neiman Marcus into court to seek relief. Two private equity buyouts, funded by billions in debt, led to years of distress and ultimately bankruptcy this year. 

J. Crew, acquired by Leonard Green and partners for $3 billion in 2011, is another that hovered at the brink for years, cutting deals with lenders to buy time until, finally, the pandemic derailed its latest plan to ease its balance sheet. 

So far at least, 2020 is not the year of mass bankruptcies among private equity retailers, but many are struggling and many others already collapsed in years past. Seven of the 19 major retail bankruptcies tracked by Retail Dive as of July 9 were private equity-owned at the time that they filed. By comparison, in years past, private equity-owned retailers made up a majority of retail bankruptcies. 

Past years saw similarly high numbers of Chapter 11s among private equity-backed retailers. Toys R Us. Payless ShoeSource. Gymboree. Brookstone. H.H. Gregg. Nine West. The Limited. Charlotte Russe. Shopko. The list goes on. Dozens of retailers — burdened by debt from leveraged buyouts and left vulnerable as retail modernized and competed fiercely with online and discount players — have filed, many of them liquidating their physical presence.

Of 104 retailers that have been through a private equity acquisition at some point since 2002, 34 have filed for Chapter 11 at least once as of July 9. That's about one-third that have gone bankrupt, with most of those filings coming in the past three years. 

Of debt and distress

Debt has made some retailers more vulnerable than ever.

Guitar Center, which has been through multiple leveraged buyouts, recently avoided a default, cutting a bond exchange deal with lenders that effectively pushed out interest payments, only after it missed a payment on a group of bonds.

Party City, which today is publicly traded but has also gone through two previous leveraged buyouts by private equity firms, is also struggling under its debt load as it wrestles with sales declines and profit losses. 

While the number of private equity-backed companies in bankruptcy this year, so far, is more modest relative to past years, the list of private equity-owned retailers in distress is long. Among retail companies with Moody's ratings of B3 and lower that fall into Retail Dive's coverage area, two-thirds are owned by private equity or have been at some point. 

For those in distress, private equity owners are typically (though not always) incentivized to stay out of bankruptcy, so they can maintain their investment. And firms that deal deeply in finance are adept with tools that can help keep their companies out of Chapter 11. That includes distressed debt exchanges and in-kind interest, which trades out cash interest payments now to free liquidity and adds them to later payments on debt. 

"Those are the kinds of things private equity firms go back to the table and negotiate in times of stress," Mickey Chadha, vice president with Moody's, said in an interview. "They do want to avoid Chapter 11, because that has a bigger chance of wiping out their equity."

As they try to keep their companies liquid and out of court, private equity firms can also be aggressive in how they interpret documentation around those companies' debt. "Private equity firms are notorious in exploiting any documentation weaknesses in their benefit," Chadha said. "That's been the case for as long as I can remember."

Fortunately for those retailers in distress, credit markets remain relatively liquid and open to refinancing deals, which wasn't a given by any means when the COVID-19 crisis began and markets went into free fall. Refinancing could keep retailers out of bankruptcy court, and potentially make a company healthier, if the deal eases its balance sheet. 

In April, Chadha and other Moody's analysts authored a report speculating that, absent government help, many retailers may be at the mercy of their private equity owners and those firms' willingness to put up capital. For now, Chadha said, private equity firms haven't injected much new equity capital, favoring instead the kinds of debt maneuvers discussed above.

"In general, private equity's predilection is not to put in new equity if they don't have to," he said. "It's as a last resort."

Of course, retail's travails aren't exclusive to private equity-owned companies. Among this year's bankruptcies are prominent publicly traded retailers, including Pier 1 and J.C. Penney. Same goes for those retailers that are on the brink of potential bankruptcy, a list that includes the publicly traded Tailored Brands, Ascena and Stein Mart (which was nearly acquired by a private equity firm this year). That shows just how wide and deep some retail segments have been struggling, both before and after the COVID-19 crisis. 

The number of private equity-owned retailers is also smaller than it might otherwise be, given the rash of bankruptcies in recent years, which knocked out many private equity-backed retailers. There has also been a measurable lull in private equity's interest since bankruptcies have rattled the sector. 

'Evolving' interest in retail plays

After a (second) binge on retail that began roughly in 2011, private equity acquisitions in the industry slowed after 2016.

After private equity acquisitions of retail companies hit 33 in 2016, they have remained below 30 deals per year since, according to Mergermarket data provided to Retail Dive.

The total dollar value of deals has also plummeted, from above $8 billion a year in 2015 through 2017, to $2.5 billion or less in the years since. 

"There has been a lay off on traditional, mall-based stores. However, there has been continued interest in discount retailers and specialty retailers and e-commerce," Perry Mandarino, head of restructuring and co-head of investment banking for B. Riley FBR, said in an interview. "I don't think there's no interest. It's that the interest has evolved, just like the rest of retail."

Private equity firms have also learned the hard way about the potentially toxic mixture of high debt levels and fierce price and technology competition in the retail industry, which was low-margin and difficult to execute in even before Amazon and other competitors added to the challenges. "It's very difficult, if not impossible, to lever up retail companies," Mandarino said.  

The investors that provide the debt capital to finance leveraged buyouts are also wary of the industry. Some investors say, "'We don't like retail,'" Will Caiger-Smith, associate editor for leveraged finance at Debtwire, said in an interview.

"It's an area where people are very, very careful what they get involved in," Caiger-Smith said. "The sentiment around retail has been pretty circumspect for some time."

The challenges have only sharpened in the COVID-19 era. "It's difficult to finance a leveraged buyout of a retailer, especially if there's not going to be much cash flow," Reshmi Basu, restructuring editor with Debtwire, said in an interview. "It's still a challenging market. Nobody's reporting terrific numbers at all, unless you were deemed essential."

During the closure period, two of the few recent major private equity acquisition deals in retail fell apart. Sycamore Partners and L Brands terminated their agreement, after a brief legal tussle, that would have given Sycamore a majority stake in Victoria's Secret, and Stein Mart and Kingswood Capital Management broke off their merger. 

Even among distressed and bankrupt retailers, interest has been sparse. Pier 1, for example, sought a buyer before and during bankruptcy, and couldn't find one. The retailer's cash burn, and market share and sales declines were so problematic that likely no private equity firm could conjure a thesis to profitably take the company over, analysts said earlier this year, well before the pandemic made retail even more difficult.

But the landscape is not completely devoid of activity. Sycamore has reportedly mulled a bid for J.C. Penney as well as Pier 1's e-commerce unit (after no buyer emerged for the retailer's full business). Sur La Table recently filed for bankruptcy with a bid in hand to be sold in Chapter 11 to a pair of private equity firms. 

"You will see transactions, I don’t think it's going to go away," Brien Rowe, a managing director with D.A. Davidson's investment banking group, said in an interview. He noted there is still interest in need-based retailers, like those that sell work apparel and supplies, as well as in retail brand assets and e-commerce operations.

Private equity interest in retail could also take a different form than the previous era's buyouts. Debtwire's Caiger-Smith said that since the pandemic crisis began, some large private equity firms — many of which also invest in corporate debt — have been "ploughing" money into "opportunistic credit investments." That is, lending to companies rather than buying an ownership stake in them, or providing hybrid capital such as convertible bonds or preferred equity.

"They understand the leveraged credit space," Caiger-Smith said. "They understand how these companies work and what it means to lend to these companies."

There is some of that in the market already. WHP Global, a brand management firm backed by two private equity stalwarts (BlackRock and Oaktree Capital), agreed to provide a secured loan to fund Brooks Brothers through its bankruptcy. 

Rowe said he is working with some private equity clients now that are in the process of setting up credit funds that could start making loans to companies in the fall, including to retailers. "You might see a multi-pronged approach" to investing in retail, he added.