Buyer's Remorse?
Slowdown in economy saps the energy from PE company businesses.
April 28, 2008
The end of a housing market boom that spurred spending on goods and services, as well as a steady climb in oil prices, have wreaked havoc on a wide range of heavily leveraged businesses.
Many of them happen to be owned by private equity firms.
The troubled companies include restaurant-chain operators, retailers, home furnishings companies and other businesses whose fortunes were closely aligned with the once-hectic housing market.
In recent years, consumers were able to readily spend on goods and services. Much of the spending was fueled by steady gains in home values that allowed homeowners to routinely take out home equity loans. Now that era of easy credit is gone. The job market is cloudy and consumer confidence is at five-year lows while expectations among consumers are at their lowest level in over three decades.
"The consumer today is under pressure. They've seen home values drop, the credit market become tighter and gas prices rise. All of these things now are causing more of a dislocation," says Gilbert Harrison, chief executive of Financo, a New York firm advising Linens Holding Co., which recently asked its lenders for -- and received -- forbearance. Linens 'n Things, as the business is known, is owned by Apollo Global Management.
A measure of distressed debt tracked by Standard & Poor's recently noted that February saw the largest gain in distress in nearly a decade. The gauge, which considers bond spreads and leveraged loans, found that media and entertainment as well as retail and restaurants as well as consumer products businesses were leading sources of distressed credit. In a separate report, the credit rating agency said it found that over half of the companies rated B- or lower with a negative outlook or ratings on CreditWatch with negative implications are companies that have been involved with private-equity driven transactions in recent years.
"Private equity presence exceeds 60% among entities rated CCC+ or lower, but the comparable ratio for entities rated B- is closer to 40%. History indicates that, on average, 43% of entities rated CCC+ or lower default within three years, whereas the comparable number for B- rated companies is 28%," the credit rating agency noted in a report.
"Many companies, as a result of the high leverage, have not been able to reinvest into their businesses," says Harrison. "In some cases they have recapitalized the business and taken out substantial dividends and now the piper is being paid."
Interestingly, the report published by S&P found that of the 11 US defaulters recorded in the year-to-date, five businesses were associated with private equity.
According to Michael Niemira, chief economist at industry group International Council of Shopping Centers, the slowdown in consumer spending was first evident in 2006 and was more noticeable by last year. The first retailers to feel the impact of the housing problems were furniture stores and retailers of durable goods as well as nondurable goods that are household-related. "Over the last year we heard about mom-and-pop stores around the country going out of business. That has changed," says Niemira.
"In this environment there are going to be a lot more situations. A lot of businesses are over-leveraged," says Harrison. "The businesses were leveraged too much when the slowdown occurred. They did not have the cash flow to sustain" themselves.
For some companies that are in portfolios of private equity giants such as Kohlberg Kravis Roberts, the problems associated with a drop in consumer spending are not immediately apparent. KKR's Toys R Us did well in the holiday season, but its Sealy Corp., a maker of mattresses, may see problems as consumers restrain spending.
Sealy, which claims to be the biggest bedding maker in the world, posted sales of $1.7 billion in fiscal 2007. But, Moody's last month warned that the Trinity, N.C.-based company may run into trouble amid deteriorating consumer spending that "will further challenge the company." The credit rating agency issued a negative outlook on Sealy, citing its weaker-than-expected operating performance and concerns it may breach a financial covenant if that performance continues to slip.
Several private equity fund managers have seen their investments within the restaurant world get hurt by the drop in consumer spending, including Wind Point Partners, Oakhill Capital Corp. and Sun Capital.
The restaurants are being hurt not just by a drop in spending tied to problems with housing; there is also the issue of rising gas prices. In its recent measure of gas prices, AAA said the current national average for a regular gallon of gasoline is $3.556, the highest on record.
"We are at the point where we are seeing more severe effects on the economy because of that [rise in energy prices]," says Niemira. Fast-food chains and restaurants have been impacted by the rise in gas prices because higher energy prices have eroded consumers' discretionary spending.
Oakhill Capital owns Caribbean Restaurants, the exclusive Burger King franchisee in Puerto Rico and the largest quick-service restaurant on the island. In March, Moody's downgraded Caribbean's corporate family rating to B3 from B2. At the same time the credit rating agency offered a negative outlook on the business, citing concerns about the company's under performance amid a recessionary economic conditions in Puerto Rico, high inflation as well as competition. The outlook also considered the company's "weakening liquidity position as represented by its very tight covenant."
Wind Point, meanwhile, saw its Vicorp business file for bankruptcy protection in early April. Vicorp, a Denver operator of 343 Village Inn and Bakers Square food chains, blamed its bankruptcy on the US economic slowdown and a jump in operating costs. Its restructuring calls for the closure of 56 restaurants.
Sun Capital, meanwhile, has seen several portfolio companies caught in the downdraft created by the housing crisis. Sun Capital's Lillian Vernon -- started by a New York City housewife with $2,000 worth of wedding gift cash -- petitioned for court protection. Sun purchased Lillian Vernon in 2006.
Sun Capital's Real Mex Restaurant chain was downgraded by S&P to CCC+ which also offered a negative outlook on the company that runs El Torito, Chevys Fresh Mex and Acapulco Mexican restaurants. The downgrade, the rating agency said, reflects "the distinct possibility that the company will breach the financial covenant of its senior-secured revolving credit facility." The credit rating agency warned that Real Mex could also breach the financial covenant of its senior unsecured credit facility.
S&P also said its rating action reflects the company's poor operating trends and the fact that covenants of its loans become more restrictive in 2008.
Sun Capital has other exposure to the consumer slowdown. It owns clothing chain Limited Stores, the clothing retailer with 229 stores, Boston Market Co., which has 550 restaurants in 28 states, and Bruegger's Enterprises, which has 277 bakery cafes in 22 states.
"There is no doubt about it -- we are feeling the impact of the recession," says Richard Hurwitz, spokesman for Sun Capital. "We knew in June of last year the economy was deteriorating and as a result of that we went to the operating team and told them, 'Redouble your efforts to create and implement cost reduction programs and restructurings.' As a result we have been taking a lot of costs out of the portfolios. We have been improving the operating processes," says Hurwitz.
While some private investment firms may be surprised at the problems in their portfolios, Sun Capital actually sought out the troubled businesses. The company specializes in control buyouts in small and mid-sized distressed underperformers. About 45% of its companies have a negative Ebitda when Sun buys them.
Hurwitz says Sun is a hybrid of a PE firm, an operating manager and a crisis manager. "We buy companies in crisis. They stay in crisis for a long time and they remain fragile into a turnaround."
Sun has 78 companies in its portfolio and last year it made 39 acquisitions. In the first quarter of 2008 it had 13 acquisitions, but Hurwitz says that pace of buying may not continue through the rest of the year.
Cerberus, meanwhile, is best known for its investment in Chrysler, but its portfolio companies also include Rafaellea Sportswear, a women's clothing firm, as well as Blue Linx, the largest building products distributor in the US which offers 10,000 products from 750 suppliers.
It's no secret that home sales have been eroded by the housing crisis, but home starts, too, have dropped and remodeling has been put on hold by many home owners.
In a report entitled "Top Trends US Building Materials Companies Face In 2008," S&P warned that the current environment will be a tough one because "it will become more difficult for companies to continue cost-cutting measures, disciplined production, higher productivity, and solid pricing that kept profits and cash flow at acceptable levels for most companies in 2007, despite overall lower volumes."
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