The keys to retail success

Despite concern over consumer indebtedness and spending prospects, the retail sector continued to attract private equity investment during the economic downturn. Perhaps surprisingly, this is also true of the sluggish recovery period since the UK economy emerged from recession, writes Markus Golser, senior partner at Graphite Capital.

Some 60 retail transactions have been completed by UK mid-market investors since January 2006, about half of them after the collapse of Northern Rock in September 2007, when the economic tide started to turn.  Ominously, the overwhelming majority of those investments remain unrealised, with exit prospects receding further against a background of weak like-for-like trading and margin pressure.

True, the impact of the recession was not as bad as first feared, with few private equity backed retailers collapsing altogether. And while many investments required balance sheet restructurings and, frequently, an injection of fresh capital, most of the original equity providers remain in control of their investments.

The economic crisis has highlighted the need for a fresh approach to generating equity returns from retail investments. The twin boosters of positive multiple arbitrage and high leverage will, for the foreseeable future, remain absent from the retail arena, leaving only significant profit growth as a viable driver of capital generation.

Alas, in these times of austerity, doubling a retailer’s profit over a three or four year period (a conventional proxy for achieving a satisfactory equity return in an only moderately leveraged investment) is no mean feat.  Recent retail success stories offer some clues as to how it can nonetheless be achieved:

–    As consumer spending habits become increasingly polarised, retailers operating at either the “value” or the “luxury” end of the price spectrum, such as Poundland and Jimmy Choo, will fare better than relatively undifferentiated mid-market brands.

–    Market-leading destination brands catering for emerging or changing consumer trends will benefit from strong demand for new products and services – as evidenced, for example, by LoveFilm.

–    “Young” fashion brands with clever marketing, PR and social media strategies (such as Jack Wills) will quickly create a strong following through word-of-mouth and group behavioural dynamics.

–    Brands with the ability to translate UK success into international expansion will multiply their turnover potential many times by opening new markets. While very few brands will be sufficiently design-led or adaptable to appeal to consumers in different geographies, private equity-backed businesses such as Cath Kidston and our own Kurt Geiger (which Graphite sold very successfully earlier this month to a US trade buyer) demonstrate growing overseas demand for UK designer products.

For the substantial number of private equity-backed businesses that do not fulfil any of these criteria, trading is likely to remain tough.  Rising labour costs in China, soaring raw material prices, price competition, upwards-only rent reviews and cannibalisation from the online channel will make it difficult to grow profit, while consumer demand remains weak.  On the other hand, for those investors that seek out differentiated brands run by inspired management teams, the retail sector will continue to offer attractive returns.

Markus Golser is a senior partner with Graphite Capital.