Fitch warns on European retail LBOs

A tough trading environment for retailers could impact negatively on leveraged buyouts and recapitalisations in the sector, according to a new report from Fitch.

Credit ratings agency Fitch Ratings has released a report titled “European retail LBOs facing increasing pressure”, indicating that recapitalisations of retail LBOs will test the support of financial sponsors and bankers as retailers continue to suffer from a consumer spending downturn.

One year after the inital transaction, the sponsor of a retail LBO would generally find itself with a good amount of cash derived from cash flow improvements. Then the question is whether the sponsor opts to keep it on the balance sheet, repay debt or return the money to their own limited partners as soon as possible.

Pablo Mazzini, associate director, Fitch Ratings

Recapitalisations, which enable private equity firms to extract funds through dividend repayments, have become especially attractive due to the current investor appetite for leveraged loans and high yield bonds, which means funding costs are low.

In October, data provider Dealogic reported that volumes for recapitalisations and refinancings in the first nine months of 2005 stood at $40.8 billion (€34.8 billion) globally, a 92 percent increase over the like period of 2004.

Commenting on the outlook for the retail sector in Europe, Pablo Mazzini, associate director at Fitch’s leveraged finance team told PEO in an interview that not all retail companies acquired by an LBO are doing badly. However, “given the highly leveraged structure of most of these companies, they may encounter difficulties in the next 12 to 18 months”, Mazzini said.

Despite tough conditions in the UK retail sector, private equity-backed high street stores Debenhams and New Look announced refinancings earlier this year. New Look, acquired in a £699 million public-to-private by Apax Partners and Permira in February 2004, announced a £750 million refinancing in May.

The same month, Debenhams completed a refinancing which reportedly achieved total capital repayments of £1.2 billion (€1.78 billion; $2.08 billion) for CVC Capital Partners, Texas Pacific Group and Merrill Lynch Private Equity. The private equity firms invested a combined £600 million of equity in the £1.9 billion buyout of Debenhams at the end of 2003.

“One year after the inital transaction, the sponsor of a retail LBO would generally find itself with a good amount of cash derived from cash flow improvements. Then the question is whether the sponsor opts to keep it on the balance sheet, repay debt or return the money to their own limited partners as soon as possible,” said Mazzini, noting that the 12 to 14 month period between LBO and refinancing for both Debenhams and New Look was “very quick”.

The risk, he added, is not in the short term, but 12 months down the line, if the trading environment remains subdued and companies are unable to improve cash flows in order to service the debt.

“There are no liquidity issues currently for any retail LBOs, although some of them are more exposed to the current trough in sales. However, when and if one arises, will private equity firms be able or willing to support these businesses, or walk away and leave these investments with no support if they have realised their investment through a dividend repayment?” asked Mazzini. “We don’t believe so, as there may be a reputation issue, but it could depend on how bad trading is, whether the company still has some prospects, either by enjoying good market share or whether the underlying sales growth is still there.”

In reference to an article in today’s Financial Times reporting that Debenhams has announced that it has doubled profits and exceeded £2 billion in sales in the year to September 3, Mazzini said that Debenhams was in a better position than other European retailers to withstand a downturn in the market due to its size, brand reputation and geographical diversification.