Suddenly those barbarians don't look quite so more than two years private equity firms were titans of capital, raising mountains of cash and seemingly taking entire industries private. Retail has been no exception. An all-star cast of familiar big brand names like Linens 'n Things, PETCO and Michaels Stores entered private equity hands with deal prices reaching 9, 10 and, in a few cases, 11 figures.

Today, though, the fallout in credit markets that has emanated from blowups in subprime mortgages is shaking these raiders. Almost overnight the easy money conditions that greased the wheels for private equity firms have vanished. Banks are already choking on hundreds of billions of dollars of massive bridge loans promised on deals earlier this year for which they cannot find a secondary market. Meanwhile, investors in junk bonds have stopped biting, putting a serious crimp in the private equity strategy of flooding the market with fresh issuances after closing deals.

Overall, concerns about a nascent credit crunch have shaken debt and equity markets to their cores. These conditions hammer private equity firms in myriad ways. With volatility returning to the stock market, figuring out the right valuations in takeovers has gotten more challenging. More significantly, funding these deals on both the front and back ends just got a whole lot harder. Lastly, will private equity funds continue to be able to raise cash in a climate where investors are becoming leery of risk?

There is no question that the private equity boom has passed its zenith, according to Carl Steidtmann, chief economist with Deloitte Touche Tohmatsu, who cites tighter lending standards and greater scrutiny of deals as the culprits.

“We will see the amount of money for buyouts begin to contract,” Steidtmann says. “We've already seen a little bit slower deal growth and we'll see that in the future…. I think there will be capital available, but there will be more scrutiny of the deals that are done.”

Some impacts have already become clear. From June to the beginning of August, the pace of leveraged buyout activity has slowed by more than 33 percent, according to research by Bloomberg. The two biggest private equity names have also had their run of troubles. New York City-based Kohlberg Kravis Roberts & Co. (KKR) has openly battled with lenders over the new, tighter terms Wall Street has demanded. Its planned IPO may never happen. Meanwhile, shares of New York City-based Blackstone Group L.P., the biggest private equity behemoth, are trading well below their June opening price of $31 per share.

Fickle financing

The biggest change private equity firms have to adjust to is the change in debt markets. To their credit, private equity players have been more careful about leverage than the corporate raiders of the 1980s. They typically put 30 percent of their own equity in their deals. The 1980s barbarians, in contrast, were borrowing 90 percent or 95 percent of the deals' costs.

Still, getting bridge financing today is much more difficult. In many instances, buyout firms have been using high-interest, short-term bridge loans to finance their purchases. For example, when Bain Capital Inc. and Blackstone Group bought crafts retailer Michaels Stores Inc. in June 2006, the firms obtained commitments to provide up to $4.8 billion in debt financing. The package, arranged by Deutsche Bank, consisted of a $1 billion senior secured asset-based facility, a $2.4 billion senior secured loan, a $700 million senior unsecured bridge loan and a $700 million senior subordinated unsecured bridge loan. Seven other financial instutions also coughed up cash to finance the deal. It was debt that could be marketed and sold later.

That kind of financing is impossible to get right now because banks are already sitting on an estimated $200 billion of this kind of debt, waiting for deals announced earlier this year to close.

With bond buyers pulling back, some deals will have to be repriced in order to go through. Last month, for example, home improvement giant Home Depot announced it was in negotiations to restructure its agreement to sell one of its supply units to Bain Capital Partners, the Carlyle Group and Clayton, Dubilier & Rice. The deal had been originally worth $10.3 billion. But because the buyers couldn't line up the acquisition and bridge financing at the terms they anticipated, they came back to Home Depot and said they needed to rework the deal or else call it off entirely.

Debt also plays a key role on the back end of private equity buyouts. The surge in the popularity of collateralized debt obligations (CDOs) — financial instruments that enable banks to slice and dice all kinds of debt and sell different risk levels, or tranches, to bond investors — created a huge market. On completion of a deal, a common private equity strategy was to have the acquired firm issue new bonds — in many cases junk bonds — that could be fed into the Wall Street shredder as fodder for CDO issues. Private equity firms used the money raised in selling these bonds to pay themselves (and their investors) back while saddling acquired companies with high debt loads.

The lack of blowups led many to believe that CDOs weren't risky, which created more demand and led to an explosion of CDO offerings. From 2004 to 2006, global CDO issuance rose 211 percent, to $489 billion from $157 billion, according to the Securities Issuance and Financial Markets Association. But, as has been widely reported by now, CDOs also commonly included subprime mortgages. And as these have gone sour, entire CDOs have blown up. It turns out, many were also greatly inflated (in some cases, at more than 70 percent above their true value).

Now, the market for investing in these bonds has dried up. Overall, banks have amassed a backlog of up to $300 billion in promised financing in CDOs and another $225 billion in collateralized loan obligations. But there is very little interest for those bonds right now. In mid-August junk bond funds reported their tenth straight week of net outflows as investors move money to safer havens. Older junk bond issuances are being sold at steep discounts. And issuers of new bonds will have to offer higher yields.

In recent issues, the spread between junk bonds and 10-year Treasuries had grown to 420 basis points up from 240 basis points in June. With 10-year Treasuries at about 4.60 percent in late August, that puts junk bond yields at about 8.80 percent. Despite that increase, spreads are still much lower than they could be. In 2001, for example, the spread was 930 basis points.

Another practice that's disappeared overnight are so-called pay-in-kind, or PIK, toggles. Such instruments gave borrowers the choice to skip a payment in lieu of grabbing more debt. Bond investors have also become wary of “covenant-light” securities, which offer few repayment restrictions.

In June, for example, KKR had to rework its $7.3 billion purchase of discount store chain Dollar General, which it intended to finance with the sale of $2.4 billion in loans and $1.9 billion in junk bonds. In order to complete the sale, KKR and Dollar General had to remove $725 million in toggles from the financing package. The toggles ended up being sold at a 10 percent discount.

Overall, 46 leveraged financing deals around the world have been pulled since June 22, according to a report in the Wall Street Journal, representing $60 billion in funding marked for mergers and acquisitions. In total, in the U.S., the volume of loans on private equity deals had fallen to $23.1 billion in August, down from a high of $47 billion in March, according to Thomson Financial.

Because of all these factors, when it is all said and done, the drop in deal volume as a result of the changed markets could be 10 percent or 20 percent, Steidtmann predicts.

All is quiet on the retail front

So far, the number of retail deals is close to the same as last year (30 vs. 29), according to Dealogic Inc. And retail currently accounts for 28 percent of the total number of LBOs, up 6 percentage points from last year when retail accounted for 22 percent of LBOs.

But those numbers mask two major facts.

For one, this year's deals have been worth a good deal less than last year's. Across the industry, the 30 retail buyouts have been worth $16.13 billion, an almost 46 percent decrease in dollar volume compared to last year's figure of about $24 billion. Moreover, the bulk of transactions — $13.94 billion's worth — were announced before the end of May, prior to the credit markets souring.

These included: KKR's $7.3 billion buyout of Dollar General Corp. on Mar. 12; Apollo Advisors L.P.'s $1.6 billion purchase of GNC Parent Corp. and $3 billion purchase of Claire's Stores Inc. on Feb. 9 and Mar. 20, respectively; and Bain Capital Inc.'s $2 billion buyout of Guitar Center Inc. on May 30.

In contrast, the deals announced this summer have been worth a good deal less. In July, for example, Lee Equity Partners LLC entered into an agreement to buy teen fashion retailer Deb Shops Inc. for $395 million. On Aug. 3, an affiliate of Sun Capital Partners, Inc. closed on the acquisition of women's apparel chain Limited Stores for an undisclosed amount.

An even bigger signal of how the change in the debt markets has affected private equity firms was that none of the familiar names were involved in the highest-profile bidding war of the summer — the chase for Barneys New York. That's exactly the kind of prize private equity firms have been chasing — and winning — for the past two years. Instead, Japanese retailer Fast Retailing (which owns the UNIQLO chain) and Dubai investment firm Istithmar battled it out.

The firms had some distinct advantages in the new, tighter debt climate. For one, Istithmar happens to be the investment arm of the United Arab Emirates government supported by its oil riches, and is not as dependent on favorable financing rates as are U.S.-based private equity firms. Fast Retailing as a Japanese firm, meanwhile, had a currency advantage as the yen has continued to strengthen vs. the dollar.

Istithmar eventually prevailed with a bid of $942 million, $117 million more than its original offer. (Meanwhile, Barneys owner Jones Apparel Group gets a nice return. That price is more than double the $400 million it paid for Barneys in November 2004.)

The other big rumor of the summer was that Macy's Inc. might be on the block. It's been about two and a half years since Federated Department Stores bought May Department Stores for $16.9 billion and eventually changed the name to Macy's. There were rumblings that both KKR and ESL Investments Inc. (the hedge fund managed by Eddie Lampert of Sears and Kmart fame) were pursuing the chain drawn by its large and valuable real estate portfolio and ample cash flow.

But that talk has quieted down.

When the price may be right

Still, as quiet as things may have gotten, no one thinks private equity funds are down for the count. After all, they still have tons of cash to invest. (As of mid-August, buyout funds had raised $139 billion globally, according to London-based research firm Private Equity Intelligence and were on pace to meet or exceed 2006's figure of $212 billion.)

More likely, they are waiting for the credit markets to sort themselves out further. Now they are biding their time and continuing to stalk potential takeover targets. Indeed, Howard Davidowitz, chairman of Davidowitz & Associates, Inc., a New York-based national retail consulting and investment banking firm, says private equity execs are still calling him on a daily basis in their search for possible buyout targets.

Retail still retains the benefits that made it a popular buyout target in the first place. Retail companies offer two attractive assets that other companies often lack — real estate and stable cash flow, according to Steidtmann. In cases when a retail chain owns a significant portion of its real estate portfolio, firms can fully fund deals through mortgage financing or sale-leaseback transactions and skip issuing junk bonds. In an environment where investors have gotten more skittish about risk, that could be a powerful incentive.

“I would think that as the year progresses we would see more retail buyouts,” says Robert Filek, partner in the transaction services group with PricewaterhouseCoopers.

Davidowitz too thinks a megadeal involving Macy's is not out of the question considering that as of February 2007, the company owned 46 percent of its 858 stores. “This is a treasure trove,” Davidowitz says, adding that Macy's falling comp sales (-1.4 percent in July) make it more vulnerable to a takeover.

Besides Macy's, he identifies those companies that own a significant portion of their portfolios, including mid-market department store chain Dillard's Inc. and warehouse operator BJ's Wholesale Club, as those most likely to become acquisition targets.

In targeting retail in this environment, though, private equity firms will have to be even more conscious about operations than before. Turning around a behemoth like Macy's might be too much of a challenge for private equity players, especially at a time when the mid-market department store sector is on the decline, says Craig Johnson, president of Customer Growth Partners, LLC, a New Canaan, Conn.-based retail consulting firm. They prefer to target companies that can be fixed within two to three years' time, an impossibility with something as large and unwieldy as Macy's.

“It may well fit the kind of profile that Eddie Lampert likes to consider, but it is quite unlikely that [a sale] will happen,” Johnson says. “And some people might think that Eddie Lampert might want to continue to prove himself in fixing Sears and Kmart before he takes on Macy's.”

Good operating metrics are beginning to matter more than they have in the past, says Johnson. He points to the difference between the Home Depot deal, where the price will likely be lowered, and the bidding war for Barneys as evidence of a bifurcated market.

“I believe that if a deal makes a lot of economic sense, it can and will be made,” he says. “If the cash flow is there and there is a way to increase it, that will be seen as a good deal, as opposed to financial reengineering and simply selling off the real estate portfolio.”

In the end, however, both Johnson and Davidowitz expect the buyout trend in the retail sector will continue. The catch is that confronted with rising prime interest rates (at 8.25 percent, compared to 5.5 percent at the beginning of 2005 and 7.5 percent at the beginning of 2006), a shakier economy and greater skepticism on the part of investors, private equity players will want to make sure they are getting value for their money.

REITs on the Block

Changing market conditions make it likely that we will see some private equity takeovers of shopping center REITs this year, says Keven Lindemann, director of the real estate group with SNL Financial LLC, a Charlottesville, Va.-based research firm. In spite of a privatization boom in the REIT sector — from 2000 to 2007, 45 REITs were taken private, at a total transaction value of $143 billion, SNL estimates — retail REITs have not been popular takeover targets because of their high valuation. Only seven of those 45 transactions happened in the retail sector, compared to 11 in the office sector and eight in the hospitality sector, and most of them involved privately held or overseas-based real estate companies rather than private equity firms as the buyers.

Now, however, retail REIT prices are falling as a result of worries over subprime debt. As of Aug. 3, community center REITs were trading at a 19.7 percent discount to premium and regional mall REITs at a 27.8 percent discount, according to a UBS report. But the massive share sell-offs that have been taking place are the result of investors' shortsightedness, says RBC Capital Markets analyst Rich Moore. Retail REIT fundamentals are still as strong as ever.

“This debt stuff is important, but it has been blown up into a bigger issue than it deserves to be,” says Moore. “Business is still very, very good.”

That's why retail REITs are likely to become more attractive to private equity players over the coming months. Lindemann predicts that we will see at least one transaction within the next year, with a likely deal value between $1 billion and $2 billion. And, because large regional mall portfolios are hard to manage, it will probably be a deal involving a small community center operator rather than the equivalent of Blackstone's record-breaking $39 billion buyout of the office giant Equity Office Properties Trust this February.

“History suggests that smaller shopping center REITs tend to get taken out more than the larger ones,” Lindemann says.